After some rather depressing news to do with debt and interest, it is again time for some uplifting information. In this step we are going to look at how powerful it can be to put extra money towards paying off a loan and how much it reduces not just the time spent on paying back the money, but also the total amount paid back.
This information will hopefully inspire you to find ways of making extra payments towards reducing your debts. As even if they are small extra payments, in the long run, thanks to that friend of ours called compound interest, it will have a huge effect.
Let’s go back to the same example as the one I used in step 21 to illustrate how credit cards work, in which we looked at an outstanding debt of $1000, at a 1,5% monthly interest rate and a payback rate of 3% with a minimum of $10. But this time you make an effort each month to pay the minimum amount (3% of the outstanding debt) and an EXTRA $25 on top of the minimum amount. Let’s see how this works out.
The first month you are again charged 3% of the $1015 debt you have got by then, so you are expected to back $30,45 to start paying off. However you add in an extra $25 to pay back, so you pay a total of $50,45, leaving your debt on $959,55 at the end of the first month. If you compare this to the original example in the previous step, at the end of month one you were left with $984, whereas now your balance is $959. A small difference you might say, but the impact will be enormous, as two things now happen. Not only are you reducing your debt a little faster, but because our outstanding balance is lower each time compared to what you would have had if we just paid back the minimum, the interest that we keep accumulating to pay back is less each time as well. Remember the power of compound interest, which comes from interest over interest over interest, and 116 months is a long time to use that power! So the faster you reduce the debt, the less time it has to exert that power.
Now let’s continue our calculations. Remember that in the previous example it took you 116 months to pay back your loan and that you ended up paying an extra $763 back on the $1000 you borrowed. If you continue to pay an extra $25 each month on top of the minimum required pay back however – and here comes the real shocking news – it only takes you 31 months to pay back your loan! That is just under 3 years, compared to the 10 years it would take you with just the minimum pay. Also guess what happens with the interest you pay? It goes down to $223, a difference of more than $500 compared to our original pay back scheme.
If on the other hand you take this strategy even further and instead of working from a 3% payment (which means that each month you pay just a little less back as your balance is less), you keep up with your original first payment of $50,45 per month, the effects are even bigger. It would now take you 22 (!) months, and $175 to pay it all off. As you can see this is a huge difference to the original 10 years it was going to take you..
Step 22 – the impact of extra payments – in detail
- Get the details of several of your debts out. You need to know the starting balance, your current balance, your interest rate and how much you are paying back monthly.
- Do a search on the internet for “debt consolidation calculator” or “debt payoff calculator”. You will get hundreds of options, select the one that is easiest to use for you. Depending on your debt, you might have a fixed monthly payment, or a minimum payment percentage (as the one used in the example above), so find one that allows you to select whichever is applicable to you.
- Plunk in the numbers and see the total amount of months and money that it will take you to pay off this debt.
- Now if you’ve had this debt for quite a while and have been paying back for quite a while, you cannot make any extra monthly payments for the months you have already paid back. So to see the effect of extra payments, do a new calculation, put in the amount that is your actual balance (not the starting amount), and see how much longer it will take to pay it off.
- Start putting in extra payments of even as low as $10, then slowly increase to $15, $25 and $50 a month. Again all of these payments might sound small, but look at the impact over time.
- See what these extra payments can do and the effect they have over time. Appreciate that there is a way out if you feel you are controlled by your debts at the moment. The first part (this step) is becoming aware, we will soon move on to action though!
That’s all, there are no commitments to be made yet in this step, as step 22 is all about raising awareness about the impact of extra payments and getting you to look at your debt repayment schemes in a different way. As you might have guessed though, this will be followed up in the very next step with an action plan for one of your debts..! Stay tuned 🙂
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.