How to Make Your Money Work For You

Interest is the Devil… Well, Sometimes!

 

I had a great conversation today.  I talked to someone who feels the same way I do about debt.  I have to say, it was a thrill to have a conversation with someone who understands what happens when interest gets added to principal on unsecured debt and when we don’t make additional principal payments on secured debt.  Ha, wow.  I just read that sentence back to myself and I can’t believe how “finance nerd” I sound.  But, I just can’t help it.  I wish I could shout from the mountain tops how important it is to understand interest!

 

If we all understood interest a little better we could save ourselves tons of money.  Even better, you can learn how to make your money work for you!  How, you may be wondering?  Well, that’s a teeny, tiny bit complicated.  Not to worry, the Dollar Lama is here to explain it for you! 

 

Now, there are a couple of different ways I could talk about this to make it more understandable and super fun!  Well, okay maybe not SUPER fun but, a little more interesting, at the very least.  One way to do that is to talk about something that everyone can understand, and that is how to pay off debt.  You see, understanding how to pay off debt is tied directly to understanding how interest works.

 

I know what you’re thinking.  “I already know how interest works.”  You may have a good understanding of it but, I find that for the most part, people don’t really understand the true nature of interest because it doesn’t serve the purpose of the lenders to make sure we thoroughly understand it.  They make their money off the interest you pay on whatever you’ve borrowed from them.  For them, the more interest you pay, the more money they make.  I could seriously go on and on about this but, I’ll save that for another rant, er, I mean blog.

 

Anywho, it’s super important to understand one very critical thing about interest and it boils down to this: interest is the price of lending or borrowing money.  This means if you are borrowing money, it’s gonna cost you.  Here’s the really, REALLY important thing to understand, interest is also means if you are lending money, it’s gonna cost whoever you are lending it to. 

 

This is essentially how a savings account works.  You keep your money in a savings account and the bank that provides the account, pays you interest for keeping your money there so they can lend it out.  Everyone gets that, right?  If you understand that, it’s a just small step to understanding that someone paying you interest is a good thing.  Conversely, you paying someone else interest is a bad thing, see?

 

So, what in the world does this have to do with paying off your debt?  It’s important to understand interest so you can make an informed decision about how to pay off debt and in what order.  Here’s an example of what I’m talking about.  Let’s say you have a mortgage, two car loans, a student loan and two credit cards with balances on them.  They break down like this:

Debt	Balance	Interest Rate	Monthly Payment
30 yr mtg	175,000	6.25	1100
3 yr car loan1	26,000	5.75	336
3 yr car loan2	3750	3.75	268
student loan	28,000	4.25	335
credit card 1	11,000	12.99	225
credit card 2	5,000	17.99	115

 

If you are making your minimum monthly payments on everything, which a lot of us are, there are a couple of questions you should be asking.  The first, and most obvious is how long do you think it will take you to pay off each debt?  You should be able to answer that easily.  The second, and most important question is how much will you have paid on each debt, once you’ve made all your payments?  How do you figure that out?  It’s called calculating the interest of a loan.  (Original and catchy, right?)

 

When you’re talking about your mortgage, figuring it out might be pretty easy if you have your closing paperwork.  You may have been given an amortization schedule at your closing.  Amortization means basically the reduction of a debt by monthly payments.  Your amortization schedule should include a breakdown of your monthly mortgage payment (if it’s a fixed interest rate, variable rates are more complicated).  It will show how much of your payment goes to the principal amount of the loan (the original amount you took out), and how much goes to the interest. 

 

If you can’t find that schedule, you can go to bankrate.com and use their amortization schedule calculator to help you figure out how much you’ll wind up paying.  Of course, this amount does not include your escrow payment, if you use an escrow account to pay your taxes and insurance.

 

If you want to know how much it’ll cost to pay off any other type of loan, you can figure it out yourself doing some complicated math or you can save yourself the grief and use the loan interest calculator at bankrate.com.  I’ve used it many times myself.  It’s super simple and it will open your eyes to the amount of money you actually paid for that life size statue of Bigfoot you charged to your credit card last year for your back yard, or that tricked out 1970 AMC Gremlin you borrowed money to buy because you just couldn’t pass it up!  Sexy!

 

The truth is, the loan interest calculator will make it painfully aware just how much it costs you to borrow money.  If you fail to understand this idea and only make the minimum monthly payment on your credit cards, for example, you will continue to suffer under the expensive weight of compound interest until you pay them off.  What does that mean? 

 

Well, here’s another fun definition to help you understand how this works, revolving credit.  Credit cards are revolving credit accounts.  That means every month, the account balance “revolves,” or rolls over onto the next month’s statement.  When it rolls over, the credit card company charges you interest on the current balance and adds it to the balance on the next month’s statement, increasing your overall balance in the process.  Then the next month, interest is charged on the total amount, including the interest that was added the month before.  This is basically how compound interest works, too.  Fun times!

 

I’ve read where some personal finance “gurus” say you should pick the smallest debt and pay if off first.  The argument is, you’ll feel psychologically satisfied with the small success of paying off a debt and will then be more likely to stick to your budget. 

 

In fact, I’ve had clients tell me that was their strategy because their minimum monthly credit card payments were a lot lower than their car payments (using the scenario above).  Their thinking is based on their income, not the interest they are paying.  They want to pay off the item with the higher monthly payment to free up more money every month.  So, they want to pay off the second car loan and put that payment amount toward one of the credit cards.  I get it, but I don’t agree with it. 

 

The smarter thing to do is pay off the debt with the higher interest rate first.  If you have any discretionary income at all, you should be paying it to the credit card with the 17.99 interest rate.  Every spare cent should go toward that debt.  Period.  Once you pay it off, start gunning for the other credit card and before you know it, you’ll be on the way to being debt free and you will have spent less money in the process!  Don’t believe me?  Go to bankrate.com and calculate the interest on those accounts.  Now do you see what I mean about why it’s important to understand interest when figuring out your budget?  Yes, I’m sure you do!

 

Before I go, I want to explain one more extra, super, double important thing.  Compound interest.  It is a thing of true beauty when it’s working in your favor.  You are probably saying, “didn’t you just say it’s a bad thing?”  Yes, when it’s working against you, like with credit cards.  However, when you can harness it for your benefit, that’s earning money without you having to lift a finger!  Do you hear angels singing?  I do! 

 

Look for the power of compound interest in things like money market accounts and Roth IRAs, or any kind of interest bearing account, for that matter.  Your first homework assignment is calculate the interest you’ve paid, and will pay, on every debt you have.  Your second is to go out and start looking for interest bearing accounts that will pay you money based on the concept of compound interest.  Now, compare the two.  Trust me, your retirement years will thank you!

 

Sincerely,

Joy Alford-Brand

Your Dollar Lama

 

P.S.  Don’t forget to check out Money Basics for a quick, fun read about money management and our online courses by clicking here to help you with credit management and budgeting.