Sunday, January 20, 2013

Pay Down Higher Interest Debt First

Look at the illustration carefully. If, as Sheri O. Zampelli says paying interest is like buying nothing, you buy more nothing over time with higher interest.

If, for example, Abe and Abby, twins, take out separate $1000 loans in July of 2012 by using their credit cards to get tickets and rooms for a long planned family reunion. Abe's card had a 20% interest on the unpaid balance, and Abby's card charges her 10%. Neither of them will make more purchases on their cards until these are paid off.

Both of them will pay a $20 minimum payment each month, at least at the beginning.

When will each loan get repaid and how much interest will that cost? 

To answer that it helps to have some basic concepts in mind. All loan repayments have two parts: the principal, meaning important or main part, is the amount borrowed. The most principal Abe and Abby will pay back is $1000 because that's the amount they borrowed.

The other part is interest: an extra amount returned to the lender (the credit card companies) for advancing money to the borrower. This area is where lenders can really put a hurting on borrowers if there are no reasonable caps or limits on the extra they can charge. Excessive interest is called usury. Communities either by custom (only charge high interest to outsiders), culture (our people never take advantage of anyone), or law (charge more than the law allows and the government will shut you down) declare what amount of interest is reasonable. The creative greed of lenders then find ways to get around those limits. And so the merry-go-round works.

The important thing to remember is as long there is an outstanding principal the lender will add interest. But as soon as that amount is repaid, the lender is "made whole" and the loan repayments end. 

Back to Abe and Abby. In a little over 5 years Abby will have her 10% loan paid off, and have incurred $299 in interest, for a total expense of $1299. 

Abe will continue to pay for an additional 4 years on his 20% loan and pay $1168 in interest for a total of $2168 for his original $1000 charges.

I will share some links if you want to learn more, especially if you have multiple loans at different rates. But first, a couple of warnings. You may see from time to time a blogger say a payday loan "is designed for quick access to cash but not for long-term use," or words to that effect. Don't believe them! Payday loans are a trap and the lenders want you to use them long-term, though you think you're only needing their "help" for 2 weeks. They are not a help to "underserved" communities because the profits leave the community, and even the wages paid are to people who often live elsewhere than the poor communities that are the targets for these storefront lenders.

Another warning: some of the articles discuss finally paying off the principal loan amount like its the only point of emotional or psychological happiness. Think of the ritualized moments in plays and movies where people burn their mortgage agreements after the house is finally paid off.

The thing is, we can set our own interim success markers! I like to compare this power we always have held to how fans of sports team react. Let's say our football team is currently losing by 10 points. It has the ball and scores a touchdown. Are fans quiet at this point? No, they are cheering! But why? They are not ahead yet, they still are behind by 3 points. However you understand why they are cheering, use that for yourself.

So, let's back to Abe. He talks to his sister and realizes he needs to get a credit card like hers! But first, he wants to pay off this $1000 faster than the credit card company wants him to. They both know that anything over the minimum is subtracted from the principal.  Remember, the longer he takes to pay it, the happier (or wealthier) the credit card company becomes. The opposite is also true: the faster he can pay the better off he is.

Abe does some calculations on a napkin while having lunch with his sister. He buys coffee and sometimes a muffin or scone about 3 times a week, that's adds up to over $60 a month. He also was going to add a couple of personal days to a business trip to see the sights—he can forgo that but keep the time off and rest so he won't feel the need for the coffee. He's been Mr. Party impressively buying rounds for his friends sometimes at happy hour. That's going to stop. An so on. He commits to his sister to finding at least $100 of savings a month and putting that money on his loan till the $1000 is paid off. And, to get started, he tells her he is not buying her lunch today as he usually does, they will have to pay 50-50. Actually, Abby instead buys him lunch as her contribution to his goal.

Abe can feel good each month now if he achieves at least $100 in savings to add to his loan payment and not wait till the full $1000 is repaid to feel good.

Okay, you've been warned. Here are some sites with alternative ways to go about repaying your debts.

As with most things, knowledge adds to your strength. Remember to read the fine print and take your time before agreeing to terms.