Americans are no strangers to debt. Between car loans, student loans, credit cards and the course, the 30 year mortgage, we have grown accustomed to and even comfortable with the idea of owing someone else’s money. This comfort with debt can lead to a relaxed, passive approach to one of the key elements of your overall financial position: debt repayment. Let’s be honest, after working hard for your paycheck, it’s disheartening to see so much of it go for mandatory expenses, such as taxes, housing and utilities. On top of these, there’s a minimum payment due for credit cards and car loans and the like, leaving precious little for us to spend as we wish. The last thing any of us really wants to do is to use some of that extra money to pay extra on our debts, especially when the balance seems daunting. Most of us are aware that paying extra now saves money down the road, but how much? Is it really worth it?
“No man acquires property without acquiring with it a little arithmetic also.” ~Ralph Waldo Emerson
Let’s take a look at a common example. Imagine that after working for a few years, you save enough to put a down payment on your dream home and need to borrow the remaining $200,000. You’ve got two options: a 15 year mortgage at 6.75% interest or a 30 year mortgage at 6.25% interest (APR). You know this is a big commitment, so you crunch some numbers. For the 15 year mortgage, you find that your payment will be just under $1,770 a month. You also find that after 15 years, you’ll have paid a grand total of $318,567.41 for the $200,000. That means the amount of interest you’ll have paid will be $118,567.41, more than half of what you borrowed; yikes! You eye the smaller interest rate of the 30 year mortgage and crunch those numbers, hoping for a better deal. You find that your payment will only be about $1,230 a month, a good $540 a month less than the 15 year mortgage. However, you then find that after 30 years, you’ll have paid a grand total of $443,316.38, meaning you’ll be paying a total of $243,316.38 in interest, more than the original amount of the loan! Even though the interest rate is half a point less than the shorter loan, you end up paying more than twice as much in interest by choosing to pay it off over a longer period of time.
So if taking a passive approach to debt repayment costs more in the long run, what kind of savings are possible with an active, aggressive approach to debt repayment?
Let’s take another look at our dream house example. If you go with the 15 year mortgage with the monthly payment of $1,770, the total amount of interest you’ll pay over the life of the loan is $118,567.41. However, if you manage to save an extra $500 every month and put that towards your loan, you’ll end up paying just $76,969.22 in interest and you’ll finish in just 9½ years! What if you’re REALLY ambitious and pay twice the minimum payment every month? You’ll finish paying off the mortgage in less than 6 years and pay only $41,357.49 in interest, almost a third of what you’d pay if you took the full 15 years!
The results are even more dramatic for the 30 year loan. By paying an extra $500 every month, you finish in just under 15 years, paying not $243,316.38 in interest, but just $106,753.81. By doubling the monthly payment, you finish in less than 9 years, paying only $60,672.95 in interest, less than ¼ of the interest you would have paid if you took the full 30 years!
These examples are summed up in the table above. As you can see, paying a little more now can reap huge financial benefits later on down the road. By making only the minimum payments, you can easily end up paying more in interest than the original amount of the loan. Obviously, not everyone can realistically afford to double the payments on all their loans. But as Brandon mentioned, nearly all of us can cut 10% from our spending without really noticing. Why not use that 10% to pay extra on your highest interest loan? Every dollar you can pay now will save you money in the long run. And there’s no risk involved! While much of the financial market investing is speculative and inherently risky, paying extra on your loans is a guaranteed way to save money no matter what the market conditions are.
“No man but feels more of a man in the world if he have a bit of ground that he can call his own. However small it is on the surface, it is four thousand miles deep; and that is a very handsome property.” ~Charles Dudley Warner
Maybe we Americans have grown a little too comfortable with debt. Perhaps we should view debt not as a friendly blank check that allows instant access to things we can’t afford, but rather as crutches: absolutely necessary at the time, but discarded as soon as possible. After all, who wants to be on crutches for 30 years?
Want to save money and pay less for your loans? Pay more!
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