Sunday, January 28, 2007

Debt Repayment: Why Rate doesn't matter.

You seen these ads: "Refinance with 5.05%!" or "Consolidate your debt with a low interest rate of 4.85%." When it comes to paying your debt, interest rates does not matter. What does interest rate really do for you? It just sets the payment. What it really comes down to is how long you are going to be in debt, which in turn determines how much interest you going to pay. The longer you are paying the debt, the more interest you are paying. So, its not the interest rate that matters, its the rate at which you pay.

Take a look at these two people:
Person A
$100,000 loan
$600/month payment
30 years to pay.

Person B
$100,000 loan
$600/month payment
15 years left to pay.

Which person you want to be and why? The obvious answer is Person B because you will be out of debt is 15 years. Keep in mind, both loans are 30 year loans.

Ok, what if the interest rate in Person A is 6% and Person B is 10%? Keeping everything else equal, would you still take Person B? At this point, most people are not sure what to do because they been trained that interest rate is the most important factor when determining a loan, when in fact it should be the least concern. The obvious answer is still Person B because you are still paying $600/month and you will be out of debt in 15 years instead of 30 years.

You are probably thinking why Person B is still better than Person A? Both loans are really 30 year loans. Like many other people, Person A pays his debt once a month, so he will be in debt for 30 years.

But Person B decided that he want to pay his debt every two weeks or bi-weekly. When you pay bi-weekly, you split your monthly payment in half and pay this amount, which is $300, every 2 weeks. This result in an extra month of payment to the year, which all goes to the principal. By lowering your principal, you are getting out of debt quicker. So Person B will be out of debt in 15 years. Even though he has a slightly higher interest rate, he can potentially save tens of thousands of dollars of interest.

Why? As I mention before, its the rate at which you pay that matters the most. You can be like Person A and pay the loan once a month and pay the full total cost of the loan. Or you can be Person B who gets out of debt faster and pay maybe just half of the total cost. Even though his interest rate is slightly higher, his net effective rate is the true interest rate he is paying. Net effective rate = (prepaid cost of the proposed loan divided by original cost) times interest rate proposed loan. You can only get these numbers if the lender shows you various amortization schedule of different payments (a schedule if you pay once a month, a schedule if you pay bi-weekly, a schedule if you add more money toward bi-weekly). The prepaid cost and time you will be in debt will vary between all types of schedule.

For example, lets say you pay bi-weekly and the prepaid cost of the new loan is $100,000 and the original cost of the loan is $200,000. The interest rate of the new loan is 8%. $100,000/$200,000 x 8% = 4%. If you just paid once a month, then the net effective rate will be 8% since you paying for 30 years. But with bi-weekly payment, its 4%.

In conclusion, there are three things you should really be concern with when it comes to repaying your debt:
1) How long are you going to be in debt?
2) How much money are you going to save?
3) And finally, what is the interest rate?

*Please note that all numbers in this post are hypothetical numbers. But the general concept still holds true if you apply it in a real loan to loan comparison.*