With debt in our lives, it will not affect credit ratings only but destroy marriage and personal happiness. This indebtedness will not allow retirement, there is negative effect that debt and its compounding interest will follow. Most people do not realize that if they are just serving the minimum sum of the debt, the accumulated debt will eventually become three times the amount you actually borrow. This is the power of compound interest on the initial loan amount. With that, you will not get out of this downward spiral, your journey towards financial freedom will become further and further away. Therefore, it is important to get out of debts. How can we reduce our debt?
You need to understand the power of compound interest and you shall never become the victim of credit card companies. Personally I have seen my closest friends fallen into the vicious cycle of credit card debt and almost impossible to break out of it.
A system to pay down your debt
I have used this method to help friends break out of the debt cycle. Through this method, you will prioritize your debt and pay off the first debt in your list.
- List debts by maturity (shortest to longest debt period)
- List debts by interest rates (highest to lowest)
- List debts by size of debt (smallest to largest)
Suggest that debt be prioritized by maturity date. Once you have prioritized debts to payoff, determine to begin paying the first debt on your list. Eliminate this as soon as possible. Review your spending and see which are the unnecessary ones which you can reduce and squeeze out more cash to pay off your debt.
Once this highest priority debt is cleared, you use the amount to pay off your next debt on the list.
For example, Kelvin has a priority debt obligation for VISA credit card, he begins to pay off the VISA card by paying $100 monthly repayment. When that debt is finally cleared after nine months, instead of using the $100 to his needs and wants, he add on $100 to $200 monthly repayment for his Master credit card debt. With $300 monthly repayment, he is able to clear his debt in the next 2 years. Using this method of adding the combined amounts from each of the previous paid off debts to the next debt, he is able to clear all his debt. Using this method, the interest expense can be reduced by one-third of the cost. Compound interest aggravates the debt but it can bring the greatest opportunity if you use it correctly. I will share in future on how to use compound interest.
What happens when we let interest expense silently multiply?
For example, amount owed on a credit card is $3,100 the card company charges only 19.9% of interest rate (instead of the 25%). Cardholder only pays the minimum monthly payment of $51.43.
How long will it take to pay off the card? It will take 39.4 years!
How much principle will be on the above debt in the first year? Only $0.29!
How much interest will be required to pay the card off? $21,216.10!
Credit cards are designed to keep you in debt forever.
There are two very important messages I like to emphasize:
- Long-Term picture: You need to think long term so you can pay off the next debt. Only you can make the decision to get out of debt. The choice you make today will impact your tomorrow. Every dollar paid in interest, is one less dollar to invest in your own future.
- Opportunity Cost: Spending money has a cost. If you choose to spend more on consumable goods instead of spending the money to pay down your debt, you must understand the dire consequences because it destroys your opportunities of the future. It leaves less money to put to work over time so that it can create more value in the future. Debts are like termites in the house, you can ignore these pests for a very long time until you realize that it becomes a very big problem!
Ask yourself the following questions:
- Do I argue with my spouse over money?
- Is an increasing percentage of my income to pay off debts?
- Am I extending payment schedules from 30 days to 60 days to 90 days?
- Am I late in paying my bills?
- Am I borrowing to pay for things?
- Do I put off medical or dental visits because I cannot afford them?
- Do I know my total debt, or I am just afraid to add them up?
Incorporate earlier mentioned system to pay down your debt, tell yourself that you will no longer become a slave to compound interest. Begin to maximize your retirement income by making compound interest to work for you and not against you.