The True Cost of Carrying Debt
In our last blog we talked about attempting to save during a lean time. One area that can affect how much we have to save is the amount of debt we are carrying; whether it be student loans, buying your first car or home, or costly credit card debt that we may have accumulated. In this blog post, we will illustrate the true cost of carrying debt. It is common to have debt. Certain kinds of debt, especially credit card debt has interest charges that can eat up your budget. For example, say you start the new year off with a $5,000 balance on a 10% APR credit card from year end purchases. But, you can only afford to make the minimum payment of $42 per month. What are you really paying for that credit card? Is it worth it to pay down that debt or save for retirement?
As you can see, by paying only the minimum balance, you are essentially staying afloat. The credit card balance has only decreased $4.19, yet you paid $499.81 in interest over the year! Additionally, if you made any more purchases on that card, you run the danger of your interest rate rising. If you are carrying this type of debt we urge you to pay off this debt quickly.
Another common debt held by families are auto loans. Similar to home mortgages, these loans have varying lengths to maturity when the loan is fully paid off. The time you have to pay off a debt is known as amortization. Borrowers have a tendency to go for the longer term note because of an attractive lower monthly payment. This is especially true when buying a new car. We shoot for that 5-7 year payment schedule instead of the 3 year term. However, this ends up costing you many times more dollars in interest over the life of the loan. Seriously consider if the terms of your auto-loan fit your budget or if you really need that brand new car at all. If you determine that you need that vehicle and have to take out a longer term amortization in order to afford it on the front end, try and make extra payments when possible. These extra pre-payments are applied directly to the loan balance, not towards interest. Doing so can save you many dollars over the life of the loan.
For example: Assume you want to purchase a brand new $30,000 car, with no money down. Your local bank gives you the following options for a potential auto-loan as seen below. The lower payment option over a 6 year term is more attractive compared to the 3 year monthly payment of $873.48. But, is it really a better option?
When a loan's maturity is extended, banks protect themselves by charging a higher interest rate. The added interest is compensation for the added risk that the borrower will default over the loan's term. As you can see in the above chart, the attractiveness of the lower monthly payment of the extended loan maturity, is offset by paying quite a bit more interest over the life of the loan.
In the end, overwhelming debt payments and costs hinder your ability to create an emergency fund and put away money for your retirement. A good financial plan should incorporate savings even if you have debt.
Coming Next: Part 4 - Saving for College
W. Joseph Irish earned a bachelor’s degree in business administration from Western Michigan University with a major in accounting and is a Certified Public Accountant (CPA) and holds a Personal Financial Specialist (PFS) designation from the American Institute of Certified Public Accountants (AICPA). Prior to joining Siena, Joe spent 15 years as Chief Financial Officer and 9 years as shareholder at a successful logistics firm that specializes in rail transportation logistics.