The key to debt reduction is principal payments. The more you pay down the principal, the faster the loan will be paid off. Note that I did...
The key to debt reduction is principal payments. The more you pay down the principal, the faster the loan will be paid off.
Note that I did not mention simple interest. Increasing the number of payments you make on the same loan has virtually no impact on your debt, whatever the biweekly-mortgage zealots out there claim.
You can understand with a simple illustration. (You can duplicate it for yourself if you have a financial calculator.) Suppose that you want to borrow $100,000 and that the interest rate is 6 percent.
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A normal 30-year mortgage with 12 monthly payments a year will set you back $599.55 a month. That’s $7,194.60 a year for 30 years.
What would happen if you made two payments a month?
Calculate the interest over 24 periods a year instead of 12 and dial in 720 monthly payments over 30 years and your payment will be $299.64 twice a month. That’s $7,191.36 a year for 30 years.
Increasing the number of payments will save you a whopping $3.24 a year in interest. Not a lot of magic there.
It also wouldn’t work very well if you had to mail the payments because the additional postage (12 times 37 cents, or $4.44) would cost more than the interest saved.
But there’s still hope.
Suppose you could arrange a money pipeline to your lender so you could make daily payments. Suppose the additional transactions were free. Wouldn’t simple interest, with daily principal payments, do magical things?
The same $100,000 loan would cost $19.69 a day. Your savings over the traditional 12 payments a year would be $6.19 a year.
No one on the planet will get out of debt simply by increasing the number of payments in a year.
What will reduce debt quickly?
Pay more per payment. This will increase the amount of principal paid per period. In the next time period, there will be less debt outstanding to accrue interest.
As a result, your next payment will require less interest, leaving more money to pay principal. The more you increase the principal payment per period, the faster your debt will disappear.
Therein lies the so-called magic of biweekly mortgages. In a biweekly mortgage, the payment on a traditional monthly payment mortgage is divided in half and you make 26 payments.
That means you make the equivalent of 13 monthly payments a year, not 12 payments. So you are paying more principal. Your mortgage will be paid off faster.
The fastest way to get out of debt altogether is to use the power of principal payments to accelerate debt reduction.
Both the MS Money and Intuit Quicken software packages have debt-reduction calculators that allow you to enter your various debts — home mortgage, car loans, student loans, credit cards, etc. — and create different scenarios for getting out of debt.
In both calculators the key to rapid debt payoff is to continue a constant total payment.
For people with multiple credit cards, the constant-total-payment strategy will produce a radically fast reduction in debt. All they have to do is stop adding new debt.
Questions about personal finance and investments may be sent to Scott Burns at The Dallas Morning News, P.O. Box 655237, Dallas, TX 75265; by fax at 214-977-8776; or by e-mail at firstname.lastname@example.org. Questions of general interest will be answered in future columns.