This article is part of our 52 week journey through Bill’s latest book, The Graduate’s Guide to Life and Money. Each week, a full excerpt from his book will be presented from beginning to end. To get your copy of his book, visit www.TheGraduatesGuide.com.
Payoff Live will you help you beat lenders.
Let’s start looking at a few simple ways to be debt free in as little time as possible. We will assume that for at least one year after graduation you were either living large, or you simply did not make enough to get by. Since then you either found a less expensive place to live or you found a roommate (unless your rent is already a great deal). In this example you are now 23 years old. You have received a $2,000 raise at work and you can easily make all of the minimum payments on your debts.
In this example you have the following debt and monthly payments:
Credit Card $3,000 $75
Student Loans $15,000 $225
Car Loan $12,000 $250
Car insurance $100
Totals $30,000 $1,450
With an income of $30,000, you can expect to bring home about $800 per paycheck (every two weeks), after deducting for taxes, insurance, 401(k), etc. With your $2,000 raise, you are now bringing home an extra $55 per paycheck. Since you already survived on $150 per month last year (what was left after you paid your bills), you can increase your spending by $70 per month and still have an extra $40 to pay off your debt.
Your best bet is to increase your credit card payment to $115 per month. Over the next year you will pay down about an extra $500 on your card. In addition, since you are paid every two weeks, you get two extra paychecks per year (during two months you get a third paycheck). If you use $500 from one to pay for a vacation and $500 from the other to pay for Christmas gifts, you will still have an extra $710 to put towards your credit card. At the end of the year, your credit card balance will be about $1,600. If you repeat this plan for another year, you will have your credit card paid off completely by the age 25.
Now you can use the $155 (another pay raise where you added $40) per month you had been paying towards your credit card and use that towards your car. By the way, your car debt is now only about $7,375. By paying a total of $405 per month on your car, plus the additional $710 per year from your two extra paychecks, your car will be paid off completely, well before your 27th birthday.
Now you have an additional $405 to add towards your student loans, plus another $40 from your most recent pay raise. You are paying a total of $620 towards your student loans, plus an additional $710 per year from your extra paychecks. Since the balance is now only $10,900, you will have it paid off by your 28th birthday!
Let’s quickly review our example. You got a $2,000 raise each year, and only used less than 40 % of it to pay off debt, so you still got to spend most of your raise. You used $355 from each of your two extra paychecks per year. Notice that you continued to use $355 even though your paychecks were getting bigger because of your raises. That means more money for Christmas and vacation. You are now 28 years old and you have no debt. Plus, you now have an extra $620 per month that no longer has to be used towards debt. What are you going to do with all of your money? I’m always accepting donations. Actually, you can treat yourself to a very nice vacation this year, or save it towards a house, or car, or do both!
If you are wondering, by the time you turn 30, assuming you save $620 per month, you will have saved about $15,000. Even more exciting is being in a position where you don’t owe anyone anything. Aside from your apartment lease obligation, you can go wherever you want. If you are not happy with your job, or you just want to move to the beach, there is nothing to stop you. Maybe you just want to enjoy the freedom for now. The choice is yours. Your money is no longer controlling you.
Okay, it seems like everybody has debt, so why is it so important to pay it off? To begin, not everyone has debt. Many of the wealthy people you see do not have any debt. In fact, many people were only able to acquire all of their wealth because they had no debt. You have already seen how debt takes away your choices. Most people who earn their way into millionaire status do so by saving heavily, spending lightly and avoiding debt as much as possible. Let’s take a look at some numbers that illustrate how damaging debt can be.
Assume for a moment that you have $3,000 in credit card debt at 16% interest. Your monthly payment is probably about $60. If you pay just the $60 minimum payment, $45 goes towards interest and just $15 goes towards your principal. This means next month, assuming you do not add any other charges onto the card, your balance will be $2,985. If you continue to make only the minimum payment it will take you over 29 years to pay off the card! By the way, you will have paid $5,300 in interest on your $3,000 charge over that time period, and that is under the assumption you never made any new charges. Now are you ready for the real kicker? If you would have been saving those interest charges during that same time period and earned an average 8% return, you would have $30,000.
Let’s recap. For the past 29 years you have paid over $5,300 in interest to a credit card company and you have exactly zero dollars to show for it. If you had invested the interest only portion of your payments for the last 29 years instead, you would have $30,000 in savings.
Here is another depressing example. Let’s assume you have a car that runs well, but it is six years old and out of style, so you decide to trade it in. You buy a new car for $21,000 minus the $2,000 trade-in for your old car, so your loan is for $19,000 at 6% for five years. At the end of the five years your car will be worth about $4,000. Your total payments over the five years were $22,039. In the end, the car cost you $24,039 including interest. If you would have held onto your old car instead, and invested those payments at 8%, you would have $27,000 in savings.
In other words the $21,000 car actually cost you $23,000 in five years. Ouch. Of course, you may be thinking, “So I paid a little extra for the car, what is the big deal?” The big deal is that instead of having $27,000 in cash the next time you want to purchase a car, you will have to get another loan, and deal with another trade-in and the vicious cycle continues. Using the method I just showed you, with just five years’ of sacrifice (driving a car that may be ‘out of style’) you will never have to borrow money ever again to buy a car. Of course you will continue to set money aside every month for your next car, but instead of losing a portion due to interest payments on you loan, you are actually gaining a portion due to interest payments (or earnings) on your investment.
So why does the interest work so hard against you? I’m glad you asked. It’s called compound interest, and when you are on the borrowing end of the deal (such as when you take out a loan or use a credit card) the compounding works against you. But, when you are saving and investing, that’s when the power of compounding works for you. In the next chapter we are going to look at ways to save and invest, and how you can use compound interest to make your money work for you.