The mere word can send shivers down one’s spine. Debt is no joke. Whenever we accumulate debt, we get to see the downside of compound interest, or interest on interest.
You think you only owe X amount, but in the end you owe X plus the interest on interest on interest that it takes, yes takes – as interest owed is not a friendly guy.
So how do you get out of a snowballing mountain of debt? How do you ensure you don’t keep owing an ever-growing pile of money? Well, let’s look at a solution.
A simple example
Meet Bob. Bob is a student. He was lucky to have parents with money and borrowed money from them at no interest (this is quite a bargain situation, as you don’t easily score such a great deal). Let’s say he borrowed R2 000. R2 000 at zero interest. (I know it’s not much, but let’s keep the example simple).
He also borrowed R5 000 as a student loan at 10% interest.
And lastly he has used his credit card for an additional R1 000, at 20% interest.
Now you’d think it would be best to pay off the bigger debt of R5 000 off first, but you’d be wrong.
With compound interest, over ten years, the R5 000 at 10% interest will have grown to R6 095 (that’s R1 095 in interest), while the ‘mere’ R1 000 credit card debt, at a high 20% interest, will have grown to R6 192 (R5 192 in interest!). For such a relatively small loan, that’s a great deal of interest you’ll have to dish out.
So the clever thing for Bob to do is to pay off his highest interest debt first. He needs to put every extra cent he has into this debt, until it is paid off. It might take some sacrifice, but it will definitely ‘pay off’ (pun intended) in the end.
Once the credit card debt is paid off, he can take the money he would have used for those repayments, and put it into the student loan. The student loan has a higher interest rate than his folks’ loan – (plus they’re less likely to put any demands on when the loan needs to be repaid), so all funds need to be used to settle this next highest interest loan.
Once paid off, he can much more easily pay off his final loan, the one to his parents, quickly and easily, as he’ll have the repayments from the credit card and student loan at his disposal.
So remember: highest interest loan paid off first, then the next highest, then the next highest and so forth.
This way evil interest paid (compared to good interest earned) won’t easily get out of hand.
There is however one other alternative, and that is debt consolidation. Debt consolidation is where you approach a bank or financial institution and they pay off your debts, leaving you with a condensed loan for the total amount. This can be a good deal if you owe money all over the place and can’t keep up with all the different repayments. With a consolidated loan you only pay one amount, at one interest rate.
So whether you pay off your highest interest loans first, followed by the next, then the next, or you decide to consolidate your debt – one thing is for sure – you shouldn’t get into more debt.
Extreme measures may be required
Cut up that credit card if you can’t control your spend, or if that’s too drastic – freeze it in a container of water. If you really need it you’ll have to wait for it to defrost (don’t microwave it – it will cease to work), which will give you time to think whether you really need to make that purchase.
Do this – and thrive in the long run
Live off cash as much as you can – meaning – if you can’t afford to buy it with money you have – you can’t afford it, and shouldn’t get it.
Forget about the Joneses and start building your financial future – one without unnecessary debt.Tags: debt, debt consolidation, interest, interest rate
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