Debt – the Basics

Posted by PhroBoy - Financial Wonderboy | Site News | Tuesday 19 October 2010 11:45 am

I believe my last post was a little technical.  However, come tax season, when you actually care about saving money on taxes, I suggest reviewing it in detail.  It could save you a lot of money.

When asking what people wanted to learn more about with regards to finances, a majority of the responses were from people who wanted to know how to avoid or get out of debt.  I thought it might be good then to start with the basics.  Debt – it’s like free money…except that it’s not free and the burden will never go away until you pay it off. This is how most retail financial institutions (e.g., banks) make money. They say “Sure! You can have $10,000 to help with your tuition, and you don’t have to pay me back until 6 months after you graduate.”

Example of $10,000 student loan

Let’s say you’re able to get a great student loan rate of 5% (credit cards can have annual rates over 20%) and your payment plan is over 10 years.  Unless this is a government student loan, you are accruing interest while you still go to school even though you are not paying anything yet.  For ease of my example, let’s assume that at the end of school, when your payments kick in, you have accrued $2,500 in interest (for you finance geeks this is a rough estimate of $10,000 accruing compounding interest over 4 years @ 5%).  That means you end school having to pay off $12,500 even though you only got $10,000 in cash for help with school.

The lending company (i.e., the bank) will set out a payment plan for you to make equal payments over the ten years you have to pay it off.  In our scenario, it roughly calculates to $130 a month.  If you multiply that times the number of payments you will be making (120) you will have paid the bank back $15,600.  Though you only got $10,000 in cash initially, you will have paid the bank over $5,000 in interest plus the original $10,000.  That stinks!  If your payment plan is over 20 or 30 years, you will pay even more in interest.  If your interest rate is higher like in the case of a credit card, you could be paying far more in interest alone than you ever received in cash.

Conclusion

That, my friends, is why the banks make so much money and why you should avoid going into debt! That’s the basics – STAY OUT OF DEBT!!!

If you can’t avoid it —

  1. Get as little of it as possible. Live like it’s not your money and you are dirt poor…because you are dirt poor when you’re in debt!  Don’t buy a new car, don’t go out to eat, don’t lose track of your budget!  If you are in debt, you should live like you are a slave to it so you will have more money to buy back your freedom sooner.
  2. Pay it off as early as you can.  Keep living like you are dirt poor even when you have a salary that indicates otherwise.  Anything you pay above the required monthly payment can pay off the balance of the debt and reduces the total interest you pay. The bank gets far less of your money that way.  (Note – some lenders require you to indicate payments specifically as “principal repayment” otherwise they will consider it as next month’s payment paid early; check your loan agreement)

To quote Dave Ramsey, “If you will live like no one else, later you can live like no one else.”  Great words to live by!
Getting into debt is easy, but getting out will be tough.  Good luck!

The next post will be on a plan to pay off your debts in the most efficient manner possible.