Tuesday, July 19, 2005

A little Savings....

Here is a lesson on compound interest for those of you who need a reminder.

Lets say you invest a total of $1000 US per month for 5 years. Your total principle would be 72,000. Nice chunk of change.

Simple interest, a flat say 4% per year would give you an additional 480 per year on your principle. Plus, now here is the beauty baby.... compound interest kicks in here. You get $ on the interest you have already saved...including interest on the interest. ( I just love saying interest on interest...) It is kinda fun :-)

So, assume again... 12,000 a year in savings (a goodly amount for sure)....5 years... compound interest at 4% on 72,000 principle you have earned 10, 195 in interest... YUP. 10,000 in interest at only 4%.

Now, lets look a loans. Mom and I were talking the other day about the value of paying off debt, before making a savings plan. The key to that philosophy has to be what debt you pay off. Now, if you are paying on a mortgage at say 5%... does it make sence to pay it down before saving money... NO. I am no math wiz, but I know this to be true.

However, lets look at commercial credit for example. Lets say you have the annual American's debt load on a Visa Credit Card. According to a report on PBS, the average American has 6900 in commercial credit debt. At an interest rate of (I am being nice here) of 11%. I have actually read figures that the actual debt rate is closer to 16,000 and the interest rates are really more like 15.9%. Also, lets look at the minimum payment (say it is $100). First the BIG assumption is that you are not going to be adding ANY additional debt.

So, lets look at some numbers.

First, paying the minimum amount a month only. 100 bucks. Guess how long it will take to pay of this debt....By making minimum payments only, it will take you 33 years and 7 months to pay off your credit cards.

Based on your current combined balance of $6,900.00, you will pay a total of $9,914.93 in interest. NICE business if you are the credit card company. OK... Now, lets say you pay 500 dollars a month....If you pay $500.00 a month, it will take you 1 year and 3 months to pay off your credit cards.

Based on your current combined balance of $6,900.00, you will pay a total of $439.34 in interest.

OK, so finally, lets say you pay 1000 a month. This is what you would have put in savings. If you pay $1,000.00 a month, it will take you 8 months to pay off your credit cards.

Based on your current combined balance of $6,900.00, you will pay a total of $193.69 in interest.

So, now if you lose 8 months worth of compound interest...what does that mean for investments?

So, you take the remaining 4 months, put it into our savings at 4% a year. Then you add the 12,000 a year for 5 years. You end up with 64,000 in principle and 72,462.32 total saved after compound interest.

I argue, that while your total is decreased, the huge disservice is to pay the minimum on the high level loan. In fact, you would pay out a HUGE amount of interest to the bank. Probably the best tactic to take is to split the difference. Get half of your "investment" income and pay down the high interest debt and put the other half in savings. One last calculation to prove this fact. Lets say you paid 500 per month on your credit card debt. It takes you just over a year to pay it off. But for simplification, lets say you are able to scrape, save and cut back on expenses so that you are able to pay it off in one year and still put 500 bucks a month into savings.

Total investment the first year, 6000. Thereafter 12,000. Total period 5 years.

Prinicple and Interest...74,895.62. But the beauty is really in the next number.

Just sit on that 74K. Don't add another dime. 4% interest for 20 years. $164,106. Simply add an additional 100 a month for 20 years....200,783. Or, instead, keep the same principle, don't add, but increase your interest rate to 6%..240,200 at the end of the period.

Get that high debt paid down, get some money in savings. Good goals.



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