April 19, 2017

Paying Off Loans Explained

dollar bills

Today we're going to talk about loans. In an ideal world we wouldn't have any loans because we would be saving up money to buy things outright. But that's not always possible. Things like college, a home and sometimes even that 65" TV1, force us to take out a loan now and pay it back over time. Sometimes life throws you a wrench and you have medical bills so large that you have to pay them over time. Whatever the reason, most people have loans.

Having one loan can feel daunting and having multiple ones even more so. Like trying to clean a messy house, it's really hard to know where to begin. And sometimes, it just feels like all your efforts are going nowhere, as if you aren't making any progress at all.

Well I'm here to tell you it doesn't have to feel that way. You can tackle your loans in an organized way, maximizing your payments and be able to see your progress. But before we begin, we've got to lay some groundwork.

Simple Interest

Most people understand simple interest. For example, if I borrow $100 with a 10% interest rate on a 3 year loan, then I owe $30 in interest in addition to the original $100 principal at the end of the loan. The interest each year is $10 (10% of $100) times 3 years to get $30 in total interest.

Simple Interest Table
YearInterestYou OweNotes
0-$100.00Borrow money
1$10.00$110.00
2$10.00$120.00
3$10.00$130.00
-$130.00Total to be repaid

Notice that each time we do the interest calculation, it's only on the original principal we borrowed of $100.

Compound Interest

In compound interest, the interest calculation is on the ( original principal + accrued interest - payments we've made ).

In the table below, we show the effect of annual compounding on your loan balance (assuming that you did not make any payments until the end).

Compound Interest Table
YearInterestYou OweNotes
0-$100.00Borrow money
1$10.00$110.00
2$11.00$121.00
3$12.10$133.10
-$133.10Total to be repaid

There are a couple things to notice about the compounding interest table. First, the amount of interest owed in a year is not fixed at $10. It keeps increasing every year as the amount you owe (principal) keeps going up. Notice that in year 3, the interest amount is already 20% higher ($12.10 vs. $10.00) than in year 1.

Secondly, the final amount owed is higher than the simple interest loan. The difference between them of $3.10 may not seem like much. But it is 3.1% of the original loan amount and the difference between the two final payments will continue to grow based on how long you have the loan (term).

Time Value of Money

As we just saw, having a loan for a longer period of time results in more interest being owed. Any loan you get from a professional source (ie. anyone other than family) will be a compound interest loan. We've seen that compound interest grows quickly over time. But how quick?

With compounding interest the principal owed will double in approximately 7.2 years with a 10% interest rate while the simple interest loan principal will increase by approximately 72%. You can easily calculate this in your head using the rule of 722.

72 divided by the interest rate will tell you how many years it will take for an amount to double.

For ex. in 72 / 10% = 7.2 years, the principal will double.
Rule of 72 for compound interest
Simple vs. Compound Interest Table
Simple InterestCompound Interest
YearInterestPrincipalInterestPrincipalNotes
0-$100.00-$100.00Borrow money
1$10.00$110.00$10.00$110.00
2$10.00$120.00$11.00$121.00
3 - 6...
7$10.00$170.00$17.72$194.87
8$10.00$180.00$19.49$214.36
-$180.00-$214.36Total to be repaid

The key takeaway here is that compound interest works over time. In fact, its effects grow with time. Notice that in year 1, both simple and compound interest is $10, but in year 8 the compound interest amount is almost double that of simple interest.

Interest Rates

We've seen the compounding over time can make the amount needed to be paid back grow quickly. The last piece of the puzzle is what interest rate you're paying. Because as we learned, the Rule of 72 determines how quickly the principal will double. A higher interest rate will mean it will take a shorter amount of time.

At a 2% interest rate, it will take 36 years for the principal to double. That's a great deal for a loan because historically inflation has run higher than that. The other end, an interest rate of 20% will see the principal balance double in just over 3.5 years. Ouch!

Background Summary

  • Compound interest is interest on top of interest
  • Compounded interest grows faster than simple interest
  • Paying the interest on a compound interest loan makes it behave like a simple interest loan
  • The longer the loan term, the more it will cost to repay
  • The single biggest factor affecting how much needs to be repaid is the interest rate
  • The amount you owe (remaining principal) does not decrease unless you make payments above and beyond the interest accrued

Payoff Strategies

Now that we have our background, let's discuss how we can pay these loans off. First off, payoff strategies require that you have the necessary income needed to make the loan payments after you've already taken care of food and housing. If you don't have those, then you need to speak with a professional about debt consolidation.

If you have the money for loan payments but just aren't seeing results that make you happy, it could be one of two things. One, it could be a motivational issue -- you like to see progress and despite your best efforts, you still have those 3 loans outstanding and it feels like it will be an eternity before they go away. Or you are good about making payments, but again, those loans don't seem to be moving. Either way, keeping your motivation high is important to keeping you on track and preventing you from slipping into bad habits.

As we look at a couple strategies, we'll use the following loans as an example.

Example Loans
LoanInterest RatePrincipal
Auto Loan3%$15,000
Mastercard9%$300
Student Loan7%$20,000
Visa14%$1,200

Snowball

They say an avalanche starts with a single flake. If you lack motivation, then one method that's worked for people is called the Snowball method3. Sort your loans by how much you owe, lowest to highest. Make the biggest payment on the loan you owe the least and make the minimum payment on the rest. This will enable you to pay the first loan off quicker and give you the motivation to keep going. Sort the remaining loans by balance, rinse and repeat. The result will be a snowball or avalanche effect that will keep you motivated while tackling your bigger and bigger loans.

If motivation is your stumbling block, this method makes it easy to feel like you're making progress. The progress is more tangible because over time you'll have fewer and fewer loans outstanding.

Snowball payoff method
LoanInterest RatePrincipal (Priority)
Mastercard9%$300
Visa14%$1,200
Auto Loan3%$15,000
Student Loan7%$20,000

Debt Stacking

Maybe you don't lack motivation, but you just don't know how to make payments. Maybe you're paying an equal amount above the minimum to each loan. In this case, we want to use a method called Debt Stacking. Sort your loans by interest rate from highest to lowest. Make the largest payment towards the highest interest rate loan and the minimum payments to the rest. This method is the one that utilizes your income in the most efficient manner to paying down your debt. Remember the graph that showed interest rate vs. time to double? What it showed was that interest rate is the biggest factor affecting how much you have to repay. Knocking off those high interest loans is the top priority to saving money.

People doing the Snowball method need the psychological boost of knocking down loans in order to stay motivated. But that means that they will sometimes be paying higher interest rates. You won't necessarily see the number of loans decreasing like the Snowball method. Don't worry though, we're going to talk about a different method for getting positive feedback and turning this into a fun game.

Debt stacking payoff method
LoanInterest Rate (Priority)Principal
Visa14%$1,200
Mastercard9%$300
Student Loan7%$20,000
Auto Loan3%$15,000

Payoff Strategies Summary

  • Snowball method makes it easy to see progress on debt by decreasing the number of loans
  • Debt Stacking method is the most efficient at paying off debt

Show Me the Money

Regardless of which payoff strategy you choose to pursue, you have to make sure you stay motivated. The best tools for doing that graph your net worth on a daily basis. Once you can look at your net worth at any given moment, it turns finance into a game and you want to maximize your score (net worth). As you make debt payments, you'll see your net worth grow. Sure it may be negative if you're under a big debt burden, but that doesn't matter ... what matters is the direction it's moving. As long as you see the debt load shrinking and your net worth going up, you're doing the right things and winning!

Years ago I used Quicken to do this. Being able to watch my debts go down and net worth go up was addicting. Nowadays I'm using Personal Capital to track my net worth over time. Just enter in your updated loan balance or connect it to your loan provider and you'll be able to see how you're doing at a moment's notice.

It doesn't matter which tool you use as long as it can be easily kept up to date and gives you nice graphs showing your progress.

Summary

  • Reducing your debt requires paying principal and interest every month
  • Minimize your interest by paying down debt by highest to lowest interest rate
  • Use the Snowball method if you have trouble with motivation
  • Gamify your debt reduction using a tool that graphs your net worth
  • Debt can be managed, there is no one perfect answer for everyone.
  • Use the info here to find what works best for you!