Are you planning to purchase a house or car?
Do you have a mortgage or auto loan you’d like to pay off?
Would you like to see your credit card debt disappear?
If you answered yes to any of these questions, I have two words for you – Principal & Interest.
Principal is the amount of money you borrowed from the lender. Interest is what the lender charges you for borrowing their money.
How Do Lenders Make Money?
Lenders make money by charging high interest rates, enticing you to borrow more money, and extending your lending period for as long as they can. Lenders are in the business of making money, and they are very good at it.
Let me show you how it works. Here are 5 examples.
Example 1: You have a credit card balance of $1000 (i.e., you owe the credit card company $1000). Your interest rate is 10%. Your friend also has a $1000 credit card balance. However, her interest rate is 8%.
Minimum Payment: Your credit card company calculates your minimum payment as 3% of your balance, which means that, at a minimum, you must pay $30 the first month (i.e., $1000 x .03 = $30). The credit card company recalculates your minimum payment each month. Therefore, when your balance is lower, your minimum payment is less (e.g., a $700 balance = $21 minimum payment; a $500 balance = $15 minimum payment).
The Vow: You and your friend have vowed to stop using your credit cards and pay the minimum payment each month. How long will it take each of you to pay off your credit cards? Who will pay the most interest? (Remember, as your balance goes down, so does your required minimum payment. Thus, you will be required to pay less and less on your bill each month.)
You: It will take you 71 months (i.e., 5 years and 11 months) to pay off your debt. You will pay a total of $1280.49 (the original $1000 plus $280.49 in interest).
Your Friend: It will take your friend 68 months (i.e., 5 years and 8 months) to pay off her debt. Your friend will pay a total of $1210.18 (the original $1000 plus $210.18 in interest).
The lender will make $280.49 from you and $210.18 from your friend.
Assuming another customer only pays the minimum payment on a $1000 balance, how much will the lender make on a 20% interest rate? $860.86 with 101 months (i.e., 8 years and 5 months) to pay off the debt.
24% interest rate? $1,332.19 with 125 months (i.e., 10 years and 5 months) to pay off the debt.
34% interest rate? $9,552.39 with 520 months (i.e., 43 years and 4 months) to pay off the debt.
By focusing on the small, ever-decreasing minimum payment, the lender entices you to think short-term. However, when you do the long-term math, you discover that you will be paying the lending company a lot of money for a long time.
Moreover, every time you use your credit card and only pay the minimum payment, you are prolonging your debt.
Note: Each lender has its own way of calculating your minimum payment. Some lenders use interest plus your balance, while others only use a percentage of your balance. If you are wondering how your minimum payment is calculated, most lenders disclose this information on your credit card statement, your terms of agreement, or the documents you received when you signed up for your credit card. Read the fine print. You can also contact your lender to ask how they calculate your minimum payment.
Example 2: You have a credit card balance of $1000. Your interest rate is 10%.
As in Example 1, you have vowed to stop using your credit card. This time, however, you plan to pay $30 every month, even if the required minimum payment is less than $30.
How will paying a fixed amount of $30 each month change the amount of interest you pay to the lender?
It will take you 40 months (i.e., 3 years and 4 months) to pay off your debt. You will pay a total of $1176.42 (the original $1000 plus $176.42 in interest). When compared to only paying the minimum payment, you will save yourself 2 years and 7 months and $104.07 in interest. (Reminder: If you only pay the minimum payment, it will take you 5 years and 11 months to pay off your debt plus $280.49 in interest).
If you pay $50 each month, it will take you 22 months (i.e., 1 year and 10 months) to pay off your debt. You will pay a total of $1098.49 (the original $1000 plus $98.49 in interest).
If you pay $100 each month, it will take you 11 months to pay off your debt. You will pay a total of $1048.58 (the original $1000 plus $48.58 in interest).
By paying more than the minimum payment each month, you reduce your lending period. A short lending period means you will pay less interest to the lender.
Note: Having a low credit card balance improves your credit utilization rate (also called a credit utilization ratio). Utilization rate is your total credit balance divided by your total available credit. Lenders use utilization rate to determine if you are a credit risk. A high utilization rate may also indicate that you are in financial distress.
Note: If you pay your credit card balance in full every month, you will not pay any interest. If your credit card offers rewards or cash back, you will still earn rewards for your purchases, even if you pay your bill in full each month.
Note: If you pay your credit card bill on time and you do not go over your credit limit, contact your lender to request a lower interest rate. They may be able to review your account and lower your rate. If the lender cannot lower your rate, ask what you can do to possibly get a lower rate in the future.
Example 3: You want to buy a house. You assess your income and expenses and decide what you can afford. You set your budget at $150,000. When you apply for a mortgage loan, you discover that you are preapproved for $300,000.
What do you do? Do you purchase a bigger, more expensive house?
Let’s assume that, no matter the cost of the house, your interest rate will be 6% and you will have a 30-year mortgage.
If you purchase the $150,000 house, your monthly payment will be $899.33. Over 30 years, you will pay a total of $323,754.57 (the original $150,000 plus $173,754.57 in interest).
If you purchase the $300,000 house, your monthly payment will be $1,798.65. Over 30 years, you will pay $647,515.59 (the original $300,000 plus $347,515.59 in interest).
When you buy a more expensive house, you pay more interest and the lender makes more money.
In addition to the cost of the house, monthly payments are another factor to consider (see the next example).
Note: When you buy a more expensive house, the realtor may receive a higher commission, which means more money in his or her pocket. Find a good realtor who will look out for your best interests. Most realtors are honest and will do everything they can to help you find a good home. However, there are realtors who will pressure you to buy the most expensive house on the market, even if you can’t afford it.
Note: Your interest rate will likely vary with the cost of your house. For this example, the same interest rate was chosen to simplify the calculations and focus exclusively on the comparison of a less expensive vs. more expensive house. However, in reality, your mortgage lender will use your credit history, asset value, the price of the house, debt-to-income ratio, and other financial factors to determine your interest rate. Some lenders may even offer a lower interest rate for a less expensive house.
Example 4: You have decided to purchase a $200,000 house. This is higher than your budget, but lower than the preapproved amount. You have the option of 1) getting a 15-year loan with an interest rate of 6% and a monthly payment of $1,687.71 or 2) getting a 30-year loan with an interest rate of 6% and a monthly payment of $1,199.10. Do you choose the loan with fewer years or the loan with the lower monthly payment?
For the 15-year loan, you will pay a total of $303,788.86 (the original $200,000 plus $103,788.86 in interest).
For the 30-year loan, you will pay a total of $431,677.05 (the original $200,000 plus $231,677.05 in interest).
In this scenario, you must decide if you prefer to pay less in interest or if you want a lower monthly payment.
Note: Although a 15-year mortgage would likely have a lower interest rate, for simplicity’s sake, in this example, both loan terms have an interest rate of 6%. When you talk to potential mortgage lenders, ask them about interest rates for different scenarios (e.g., cost of the home, length of the mortgage, percent of the down payment). Although they may be a little annoyed with you, most lenders will calculate – and recalculate – monthly payments and interest rates for varying scenarios. Write down the calculations, compare them, and make the decision that works best for you and your family.
Example 5: You have decided to purchase a $20,000 car. You have saved $5,000 for a down payment on the car. When you arrive at the dealership, the salesperson tells you they are running a special for zero down payment, and you qualify.
The auto loan has a 5% interest rate, 72-month loan term, and you are not trading in a vehicle. Do you choose to pay the down payment or not?
With no down payment, you pay $322.10 a month. Over the course of the loan, you will pay a total of $23,191.14 (the original $20,000 plus $3,191.14 in interest).
With a $5,000 down payment, you pay $241.57 a month. Over the course of the loan, you will pay a total of $22,393.33 (the original $20,000 plus $2,393.33 in interest).
Note: If you increase or decrease the amount of your down payment, your monthly payment and loan term may change.
Note: This example does not include taxes or fees, which vary by location. Before purchasing a vehicle, research the taxes and fees in your area. Find out how they will affect your loan or monthly payment.
Note: Have you ever wondered why car salespeople ask what you want your monthly payment to be? Primarily, they ask because they want you to focus on the smaller number of the monthly payment instead of the larger number of the total price of the car plus interest. Secondly, they ask because by extending your loan term to 60 months or 72 months or 84 months, they can offer you a lower monthly payment. However, remember that a longer loan term means they will make more money off of you. Also keep in mind that 60, 72, and 84 months translate into 5, 6, and 7 years of car payments. I told you lenders were smart. They do their best to get you to focus on smaller numbers and think in months instead of years. Before going to a car dealership, know what you want to pay. Do the math.
Pay Off Debt Fast
The fastest way to pay off debt is to pay on the principal.
When you pay on a loan or credit card, the first part of the payment goes toward interest. Yes, the lenders get their money first. Whatever is left over goes toward your remaining principal.
For example, you just purchased a $20,000 car with a 5% interest rate, 72-month loan term, and no down payment. Your monthly car note is $322.10. When you pay your first bill, $83.33 goes to the interest and $238.77 goes to the principal. After paying your bill, you still owe $19,761.23.
Similarly, you purchased a $200,000 house with a 6% interest rate, 30-year loan term, and no down payment. Your monthly mortgage payment is $1,199.10. When you pay your first bill, $1,000 goes to the interest and $199.10 goes to the principal. After paying your bill, you still owe $199,800.90.
As you can see, those initial monthly payments do not go far. Moreover, this process happens every month, which is why it takes years to pay off debt. Sadly, by the time you finish paying for your purchases, your car may be falling apart and your house may be in need of repair. The car salesperson will welcome you back with a smile, and the bank will be ready to offer you a home equity loan or the option to refinance. It’s time for the lender to make more money.
Note: Depending on your situation, refinancing your mortgage or getting a home equity loan can be good financial options. Research your options and decide what is right for you.
Let’s Talk About Principal
In contrast to paying the exact amount that is listed on your bill each month, if you put extra funds towards the principal, you will pay off your debt faster.
For instance, on your $20,000 auto loan, pay the required monthly payment plus put an additional $100 toward the principal every month.
You will save $864.82 in interest and pay off your car loan 19 months early (i.e., 1 year and 7 months early).
The tables below demonstrate how paying extra on the principal decreases your loan amount. The same concept applies to mortgages and credit cards.
For credit cards, paying additional money is called an extra payment (not principal). However, the bottom line is that by paying more than the minimum payment, you will pay off your credit card debt faster and pay less interest.
Pay Off Debt Easily
The easiest way to pay off debt is to make principal payments automatic. Some lenders make it easy for you. They will automatically deduct your regular payment and your principal payments from your account. All you have to do is set up the process.
Some lenders make the process moderately difficult. You have to check a box or enter a specific amount for the principal each time you make a payment.
Some lenders make it extremely difficult for you to make principal payments. First, you have to figure out how and where to send the principal payments, because their regular payment system is separate from their principal payment system. Then, you have to write a check and mail the principal payment because there is not an online or automatic system.
If you are working with a lender who makes it difficult to make principal payments, take heart. Remember, their goal is to make as much money as possible and your goal is to pay as little interest as possible. Think of it as a little competition – one that you will win.
Make the process easier for yourself by printing cheap or homemade address labels so you don’t have to constantly write the lender’s name on envelopes. If possible, print the address directly on the envelopes and have them ready for mailing future payments.
If the lender requires you to send a letter with each principal payment, type the letter, print a dozen copies, and sign and date the letter before you mail it.
Do whatever you have to do to make those principal payments.
Pay Off Debt Early
When would you like to pay off your debt?
To pay off your debt early, think about how much extra money you need to put towards the principal of your loan. The more money you contribute to the principal, the earlier you will pay off your debt.
To find out how fast you can pay off your debt, use a loan calculator. There are dozens of calculators out there. Here are a few that are easy to use.
Credit Card Calculators
Credit Karma - https://www.creditkarma.com/calculators/debtrepayment
Dave Ramsey - https://www.daveramsey.com/mortgage-payoff-calculator
The Mortgage Reports - https://themortgagereports.com/mortgage-calculator
Car Loan Calculators
Calculator.net - https://www.calculator.net/auto-loan-calculator.html
General Debt Calculators
Calculator.net - https://www.calculator.net/debt-payoff-calculator.html
Calculator.net - https://www.calculator.net/amortization-calculator.html
Credit Karma - https://www.creditkarma.com/calculators/amortization
In addition to knowing how to pay off your debt, there are a few things to remember. Make sure you pay on the principal, watch out for penalties, request a detailed statement and an amortization schedule, and do the math.
1. Pay on the principal. Adding extra money to your bill payment is not the same as paying on the principal. Extra payments are usually applied to the next month’s interest. Although some lenders may apply a small portion of your extra payment to the principal, generally, the entirety of extra payments do not go directly to the principal. You must specify, either in writing or by selecting a specific section on an online payment system, how you want the lender to apply your payment. When in doubt, ask your lender to clarify the process. Always verify that your principal payments are indeed going towards the principal.
2. Watch out for penalties. Check to make sure there are not any penalties for paying off your debt early. Some lenders charge fees for early payment. If there is a fee, do the math to determine what is most beneficial for you – sticking to the lender’s payment schedule or paying off your debt early by paying the fee.
3. Request a detailed statement. Does your lender provide you with a detailed statement showing all of the payments you have made since the inception of the loan? If so, your lender may send the statement in the mail, or it may be available through your online account. If not, ask your lender for a detailed billing statement showing all payments, including how your payments were split between principal and interest.
4. Request an amortization schedule (also called an amortization table). Amortization is the act of paying off debt in equal installments over a specific period of time. Although amortization tables are usually associated with mortgages, an amortization schedule can be generated for any type of loan. An amortization schedule is simply a table that shows the loan amount, loan term (e.g., 30 years, 72 months), payment period (e.g., monthly, quarterly, yearly), and how much of each payment goes towards interest and principal.
With mortgages and car loans, initially, a small portion of the payment goes towards principal. Over time, more of the funds go towards principal and the amount going to interest gradually decreases.
Your lender may send you an amortization schedule, or it may be available via your online account. If your lender does not provide access to an amortization schedule, you can create your own using an online calculator (e.g., https://www.calculator.net/amortization-calculator.html or https://www.creditkarma.com/calculators/amortization).
5. Do the math. When considering multiple strategies for paying off your debt, do the math first. Consider all of your options and decide which loan terms are best for you. Don’t let the lenders have all the fun. You are in control of your finances. Pay off your debt on your own terms.
With discipline and planning, you can pay off your debt faster, easier, and earlier. Simply remember these two words – principal and interest.