It’s time to start looking at an area of your finances that makes many people nervous, scared and / or depressed, leaving them ignoring rather than analyzing and planning how to deal with that very same area: debts.
Yet in order to become financially independent and in total control of your finances, it is important to understand how debts work and how even seemingly small debts or amounts can make a tremendous difference to your long-term finances.
In step 4, you listed all of your debts, so you should have a good idea of how much debt you have and how much you are paying towards amortizing these loans. In this current step we are going to look at the effects of debt and how much extra you end up paying on any long-term debts.
Let’s imagine you have a debt of $3000 against a yearly interest of 8% and 5 years (60 months) to repay the debt. That means you pay a minimum monthly amount of $61, which might or might not sound like a substantial amount to you. But let’s see what would have happened after those 5 years. Due to the interest and the total time that you are paying money back for, at the end of those 5 years, you would have paid a total of more than $6650 back, which is $650 more than what you originally took out!
Now 8% is a relatively low percentage for a loan, many loans range from somewhere between 11% up to even 18% or more. Let see what happens if you have a slightly bigger loan. Imagine you have $10.000 in outstanding debts against a 14% annual rate and a total of 7 years to pay back. In that case you pay back a minimum of $187 a month, substantially more, as the original loan was higher, but the interest rate is also substantially more. In this case at the end of the journey you would have paid back a total of just under $16.000, almost $6.000 more than what you borrowed!
As you can see, the loans industry is a very lucrative and interesting business for any loans provider. I want to now look at another special type of loan, the one called “credit cards”.
Credit cards have an incredible attraction and that is that they allow you to pay for something even if you don’t have the actual money, without having to apply for a loan. In essence a credit card is a loan system and every time you use your credit card, you take out a (small or not so small) loan from your bank. At the end of the month, the bank will present you with the total amount of loans taken out and you will be required to pay it back.
Up to here nothing wrong and in theory no problem. The problem arises if you don’t actually have the money at the end of the month to pay the money back. As then the bank will say: we gave you money to spend, you can’t currently pay it back to me, so we’ll start charging you interest. Suddenly the €1000 that you thought you spent is no longer €1000, as you’re being charged 1.5% interest rate a month. Not so much of a problem you might think as 1.5% is not so much…The 1.5% rate is the monthly rate however, which means that over the year you’re talking about a 19,5% interest that you pay.
Again, all of this is not particularly a big problem if you can pay back the $1000 and $15 in interest the month after. In that case instead of spending $1000, you paid $1015. Not a big deal maybe. The bank is also happy as they made $15 in a month’s time on the $1000 they lend you. But the bank also knows they can make even more money if you don’t pay the full amount back in one go, as for every month you have an outstanding balance, you need to pay the extra interest rate. So they put out a proposal, knowing that you are unlikely to have the full $1000 + $15 to pay back the next month (why else did you need to use credit in the first place?), so they might offer you a very generous payback scheme in which you only need to pay back 3% of your money a month with a minimum of $10 a month. That indeed is generous as it means you only have to pay back $30 a month to start with and after that you need to pay back less each time as your outstanding debt decreases!
Yes, generous it is, but not for you, but for the bank. Let’s see how this payback scheme works out. After the first month you owe $1000 + $15 interest rate, you pay 3%, so $30,45, and you’ve now taken your loan down to $984,55. (See the problem already? Even though you paid $30, almost 50% of that amount was used to pay off the interest rate only!). After the second month, you are due $984,55 + $14,77 (=1,5% interest), you pay 3%, and outstanding balance is now $969. Again only roughly 50% of your money was used to pay off your original debt, the rest to pay interest. In this way, by the time you finish paying off your original $1000 loan, you’ll be 116 months down the road, i.e. almost 10 years later! What you’ve paid back to the bank is no longer $1000, but over $1763! So you paid an extra $700, i.e. over 70% of the total amount. Suddenly that offer does not seem so generous to me..!
Step 21 – How loans really work – in detail
You’ve hopefully seen from the above calculations how tremendously expensive loans are in the long run. You’ve probably also experienced first hand from any loans that you already have how loans can tie you down and restrict your financial freedom by making a constant demand on your finances.
Step 21 is simple and potentially very difficult at the same time:
- From here on commit to not taking out any more loans. Ever. For anything. (Not a new car, your wedding, a holiday, a baby… nothing). Write it down on your goals list.
- Take out all of your credit cards and put them out on a table in front of you. Not just credit cards from the bank, but any credit card you might have from a store or company.
- Count how many you have.
- Now for the hard part: keep just 1 credit card. I’ll write that again in case you thought that was a typo: keep just 1 (one) card. Ditch the rest. You don’t need more than one card. One card is okay in case of emergencies. More than one card is not okay as long as you don’t get your finances sorted and your spending under control.
- Get rid of the extra cards: cut them in half or get them destroyed in some other way. Don’t take them back to the bank yourself, as the people there will just convince you to keep it.
- From here on, commit to only ever paying for something if you have the money for it either in your account or in cash. If you don’t have the money for it, don’t buy it until you have saved the money together to get it debt-free. (The only exception to this might be certain sensible investments – although opinions differ on what makes a “sensible” investment).
Depending on how many credit cards you had and how often you used them, this might have been a very difficult step for you, but remember: it is all for the best, and long-term it will all work out! Just be firm with yourself for now but know that the only way to get in control of your finances and become debt free is to take any temptation away.
Read more about my 100 steps mission to financial independence or simply decide to take control today and join us on our step-by-step quest on how to make your finances work for you, starting with step 1.