The Science of Debt Repayment

If you live in America, you are probably in debt. Whether it be credit cards, car loans, students loans, a mortgage, or one of the multitudes of other ways of obtaining credit, somebody probably gave you money to buy something that you wanted now instead of waiting to save up the cash to do so. It is so useful – even essential – to the lives of many, yet it can also get you into serious trouble. However, if you can be responsible with credit, it can enable you to obtain social and economic security with very little long-term financial consequences. Here are some of the most basic ways to manage your cash and debt without going underwater.

The Basics

Remember the principle of compounding interest from elementary school? If you invest $1,000 dollars and get a return of 5% per year, that money will grow exponentially. This is because while you earn $50 the first year, you will earn $52.50 the second year – 5% of the  original $1,000 investment, and 5% of the $50 gain from the first year. Because of this “interest on interest” calculation, compounding makes investment a powerful way to grow your money over time. In fact, over 25 years, your $1,000 dollars will have more than tripled in size to $3,386.35.

Unfortunately, this also works for credit. If you carry a balance of $10,000 on your credit card with an annual interest rate of 12%, you will get charged 1% interest on that balance every month. This means that you are paying $100 extra per month for borrowing that money; in most cases, the minimum payment given to you by your credit card company is lower than the amount of interest you’re getting. For example…

January Balance: $10,000
Interest Charged: $100
Minimum Payment: $75
February Balance: $10,025
Interest Charged: $100.25
Minimum Payment: $75
March Balance: $10,050.25

Which brings us to our first rule…

1) Always Pay More Than the Minimum…

For the simple reason above, your debt can increase exponentially if you only make the minimum payments given to you by your credit card company. The only way to get out of debt is to pay the interest accrued every month plus some of the balance on your card. Also, remember that for anything you pay, it is applied to interest first.

2) …Unless You Have a Tiny Interest Rate

Say you are able to take out a $10,000 loan at a really low rate – something in the neighborhood of 3-4%. If you take that cash and invest it in a moderately safe investment, like a bond fund, you could make more in interest from that investment than you are paying on the loan. With a 4% interest rate, you would be charged $300; with a 6% return, you could make $600. The result is that while you are making the minimum payments, you are collecting much more from your investment over the life of that loan.

This same principle applies to repayment of a loan that was applied to something like a car or tuition. For example, I currently have a student loan of around $10,000 at a rate of 3.76% and a minimum payment of $100 per month.. I could easily make a $500 payment towards the loan, but why would I? Reducing the balance by an extra $400 would save me from having to pay 3.76% interest on it, but it would also eliminate the opportunity to invest that $400 and get a higher return on it. So basically, always put your money where it will either save you or make you the most, whichever one is larger.

3) The Balance Snowball Method

If you have more than one loan or credit account to repay, this method is one that will allow you to pay it off faster. Say you have four loans, for $1,000, $2,000, $3,000, and $4,000. Each has a different interest rate and payoff period, and minimum payments of $20, $30, $50, and $65 per month respectfully. By this method, you make minimum payments on all but the smallest loan, to which you pay an extra amount every month. Then, when that $1,000 loan is paid off, you take the same amount of money you were paying to the first loan every month and apply it on top of the minimum payment for the second smallest loan. When the second loan is paid off, you take the payments from the first two loans and add it to the third, and so on. This way, your total monthly payments are not decreasing despite one or more of the loans being paid off, allowing you to pay off the principle faster and save money in the long run.

4) The Interest Snowball Method

This method is similar to the first, except you choose which loan to pay off first based on the interest rate of the loans. By paying off the loans with the highest interest rates first and then using those payments towards the other loans, you end up saving the most money in the long run. The balance snowball method may be more appealing psychologically, because there is a better chance that you can reduce the number of loans you have faster and feel better about the amount of debt you carry as a result; however, it makes much less sense mathematically.

Use credit responsibly, but pay off that credit even more responsibly!


2 thoughts on “The Science of Debt Repayment

  1. Pingback: Pay More Than the Minimum on Your Credit Cards | Price Insurance and Financial Group – A Nationwide Insurance Agency

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