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| Getting Ourselves Free of Debt, Part One |
| Lou Haines | 1/5/09 |
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A recent survey from the Forbes 400 Richest People in America asked, "What is the most important key to building wealth?"
75 percent of them stated that "becoming and staying debt free is the #1 key to building wealth."
Is there a way to become debt-free, even in today’s economy? The answer to that question is a resounding yes for most people, especially if they are open to learning new money management approaches and are willing to incorporate them into their household and/or business budgets. Learning and applying these techniques is easier than you may think. The following article will attempt to introduce the reader to some new and innovative approaches to accomplishing debt-freedom in as short a time as possible.
 First, it is important to examine and understand debt, loans and the interest that we pay on those loans. According to a recent report in U.S. News & World Report, financial illiteracy is prevalent in our society. Personal debt surpasses the country’s national debt. 40 percent of wage-earners spend more than they earn. Home foreclosures are at an all time high, up almost 60 percent from a year ago.
So, is there a community college we could attend to learn about debt and money management? Did our parents teach us good money management? Are we teaching our children about debt avoidance and sound money management? What do we do to address this financial illiteracy issue?
Einstein was once asked, “What is the most powerful force that you have encountered in your lifetime?” His answer was, “Compound interest”. He went on to say, “Those who understand interest earn it. Those who don’t, pay it.” Unfortunately, few in our society understand interest, especially compound interest. For those of us who have experienced the pleasure (and displeasure) of inking our signature to a mortgage loan, the resulting shock of compound interest has probably hit us in a nuclear sort of way. “I’m paying how much interest? But I thought this was a 6 percent loan!!”
Let’s look at a common sense breakout of a typical, fully amortized $300,000, 30 year mortgage loan at 6 percent interest:
- During the first 5 years 80 percent or more of our monthly payments go to interest.
- It will take 18 years, 6 months before as much of your payment will go toward principal as goes toward interest.
- By the time the loan is paid off you will have paid a total of $347,514.57 just in interest!
- That means you have paid $647,514.57 for your $300,000 mortgage.
In simple interest terms, this 6 percent loan is actually collecting 216 percent interest. You have paid 2.16 times the original loan amount. Yet, using “banking math”, it is a "6 percent" loan.
If these numbers sound a bit outlandish to you, you may want to confirm them by checking your own amortization schedule that can be found in your loan documents. Or you can go to your lender’s website — it should be available there.
In today’s economy, equity in our homes becomes increasingly important. Most of America’s middle class wealth/net worth is found in real estate owned. Unfortunately in this time of a down real estate market, much of that wealth has vanished. Since this area is so important to our net worth, it requires the greatest part of our focus if we are to reach our goal of debt-freedom.
There are but 3 ways for any of us to build equity in our homes:
- We can continue to make our monthly mortgage payments and allow the equity to build slowly. This strategy is effective only if home values are staying even or increasing. Even then, it is extremely slow.
- We can count on the real estate market to grow and the value of our homes to increase proportionately.
- We can apply more money to our mortgage. But how much we apply and when we apply it is critical to maximizing equity acceleration and interest cancellation.
So, at this point, it is perhaps a good idea to return to the concept of education. How do we become better money managers? Returning to the article in U.S. News & World Report, it states, “Financial illiteracy is getting Americans in hock”. It goes on to state that “many consumers don’t really understand what they are getting themselves into, especially in the area of home mortgages”. Additionally student loans and credit card debt is plaguing young people just out of college, lured by the call of easy credit. Much the same way as we previously analyzed a common sense breakout of a mortgage loan, let’s take a look at an example of credit card debt.
A recent credit card TV commercial features an individual who proudly exhorts, “I want it all and I want it now”. Let’s explore the mathematical wisdom of that ‘sage’ statement in a short story:
Joe really wants that flat screen TV but is unable to pay cash. He checks his credit card balance (using his smart phone on the TV commercial) and finds that he has room for this charge and can afford the minimum monthly payment. He gets a “bargain” for $2000. Let’s assume, for this example, that this is the only charge that he has on this credit card and that he pays only the minimum monthly payment. Based on approximately 17 percent interest, it will take Joe 30 years to pay for his $2000 TV; he will have paid $8000 in interest for a total of $10,000—five times the original cost of the TV. He would have had to earn over $12,000 to pay the $8,000, since the government gets paid first. If Joe would have taken that same $2,000 and invested it at 10 percent, he would have earned $158,699 in the same 30 year period.
Most of us try to pay more than the minimum monthly payment in order to avoid costly interest as well as staying under our credit limit. That, of course, is a good idea but the timing and exact amount of each payment is critical to realizing the maximum return that you will receive. So how in the world do we figure that out?
Read Part Two tomorrow…
To learn more about innovative methods for becoming debt-free, please contact Lou Haines or Frank Elge at Debt Solutions (970-731-2102). There is no charge for your initial consultation. |
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