Wednesday, April 6, 2011

Debt and the frugal family 2

To control debt, you have to understand how much it costs you. For instance, last month, my total credit card bill was just under $600. The minimum payment, had I chosen that route, was $15. At that rate, it would have taken 5 years to pay off at 14.65% interest, and I would have paid $824 total. So, $15 a month isn't bad looked at monthly, but think about the fact I would have spent over $225 to "borrow" not quite $600 for 5 years. Paid off at just $21 a month, it could have been paid off in 3 years, for $743, "saving" $81, but still costing about $145 for less than $600. (I chose the most economical route, I paid the full balance---which included all my groceries, gas, utilities, and once-every-two-month trip to a department store---and paid $0 interest or fees).

A lot of people will think, OK, so it's a few dollars. Multiply that by 10 (much closer to the balance people carry), and it starts sounding grimmer. If the balance was almost $6000, the monthly payment would, I assume, be $150, and over 5 years, you'd pay $2250 to borrow that $6000. And that's IF you don't take a cash advance (those are at an even higher interest rate) or make a late payment, which will add late payment charges and probably trigger an interest rate increase. Dunno about you, but I can think of lots of things I could do with an extra $2250, and also keep in mind that if you keep using the credit card for those 5 years, the payoff date never gets any closer.

So, how to get out of debt. First, cut expenses to come up with a little extra money every month (see previous posts for suggestions), and make a list of your debts---total owed, monthly payment, and interest rate. Sort them into two lists, one by total owed, one by interest rate. In general, paying off the highest interest debts first makes the most financial sense, then car, college, and mortgage debts. But if you have several high interest consumer debts, another approach is to pay off the debt with the smallest balance first. 

I thought this was counter-intuitive, but I did some calculations, and this actually works too in the right circumstances, mostly because you eliminate one of the minimum payments more quickly. And people are often inspired by being able to mark one of those debts off their list too. Whichever approach you take, target consumer debt before anything else because those are almost always at rates at least twice that of car or house loans with pretty stiff penalties if you make a mistake.

By the way, I consider mortgages to be fishy in how they work, and I won't even touch the balloon or adjustable rate mortgages. Those look great on paper when you're buying, but seem to be a disaster in real life for people. But a fixed rate mortgage apparently has the interest somehow redistributed so you pay 75% of the interest by the time you're halfway through the mortgage. To me, that seems...fishy because that means the effective interest charge early in the mortgage is higher than what you agreed to, and lower later, and you effectively build equity much more slowly. And, in most cases, if you don't specify clearly in writing (and crossing all the t's and dotting all the i's) that any extra payment you make is for the principal, they apply it to the next payments due, so they get their interest anyway. But a fixed rate mortgage is the best option for most people who don't have the capital to buy a home outright.

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