You’ve probably heard the saying: “The straw that broke the camel’s back”. It points to the idea that small things add up, until the addition of one last small thing has a very big consequence. If you have kids, you know exactly what we’re talking about. Kids do one little thing after another. But then, all of a sudden, watch out! Flames start coming out of your ears. Small things matter.
The same is true for financial matters, especially debt. Each additional point of interest or extra month of payments adds up.
Interest is a small thing that matters a lot
To understand the impact of this, let’s take a look at how payments are applied to a loan. Credit cards are the easiest to understand. Each month, you owe 1/12th of your annual interest rate. The difference between the interest you owe and your minimum payment is the amount you pay to reduce your balance.
For example, if your interest rate is 12% (very low for a credit card), then your monthly interest rate is 1%. If your balance is $5,000, then you owe $50 interest for that month. If your minimum payment is $60, then your balance will be reduced by $10 (that’s the $60 minus the $50 in interest) and the next month you will pay 1% on $4990 or $49.90 in interest.
So how does the credit card company calculate your minimum payment?
Each credit card company has a number of months they expect you to take paying them back. The more months they use, the more interest you will pay. Each credit card statement has a box on it which will tell you how many months or years it will take you to pay off the balance, if you pay the minimum. For very low balances, you may find 2 or 3 months listed as the time to pay it off. On larger balance, 5 years is not unusual and it may run as high as 20 years. Wow!
So, how do you reduce the payback time? Simply increase the amount of each payment. Any amount over the minimum payment will be applied to your balance. You might think that if you double your payment, you will cut the number of payments in half. But it is actually much better than that. $5,000 for 20 years, at 17% interest, has a monthly payment of $77.17, increasing that payment to $90, will cut the number of payments in half. Doubling your payments, to $154,34, will pay it off in 45 months. So from 20 years, doubling up will reduce it to a bit less than 4 years.
Small things can make big differences in a good way too.
What about changes in interest rate?
Borrowing $30,000 for a car, at 10% results in a payment of $637.41 for a 60 month term. Over the life of the loan you will pay $8,244.68 in interest. But if the loan rate is just 1% lower, your payment drops to $622.75. While that seems like a small change, it will result in paying $879.64 less in interest. That may seem like a small amount when you are buying a car worth over $30,000, but instead, think about having 8 $100 bills and 4 $20 bills in your pocket.
Again, small things make a big difference.
One of the games our minds play with us, is we become willingly deceived by scale or our internal desire to own something. When we want to buy a new phone, or a new TV for Christmas, we think about the fact that it will only cost $25 per month rather than a total of the actual $900 cost or the $1116.53 we’ll actually end up paying back. Or when we find out that a dealer has the car we want in the color we want, we miss the fact that the interest rate is 1% higher than another dealer. In fact, most of the time, we don’t even consider the interest rate until after we have already decided to buy the car.
If the little things don’t seem that important, realize that professional investors do not measure returns in whole percentages. They measure them in basis points, which are one hundredth of a percentage, or two whole zeros past the decimal. They realize that very small differences can make a world of difference when it comes to money.
Pay attention to the small things now and you’ll find you have more of the big things you really want in the years to come.
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This information is intended for informational and educational purposes only and not as legal advice. If you have concerns about your credit report, harassment, identity theft, illegal collections activity, garnishments, or property liens, you should consult an attorney who specializes in consumer rights and defense.