13 September 2012

Hacking Your Debt: Pay Your Bill Immediately

caused by low minimums
I'd be over 100 before I paid it off
sending only the minimum!
When it comes to paying off debt, it can seem as if no progress is being made and you'll never get that balance down. Now understandably, that's just an illusion since as long as you're not adding new debt, you should be making some progress on those balances. However, most repayment plans are structured to provide a certain amount of return to the lender that gets paid by guess who--you! Paying only the minimum payment on certain types of credit can result in mind-boggling repayment periods, as pictured on the left. That piece of information they provided me is actually a direct result of the Credit CARD Act passed in 2009. Under that legislation, companies must now disclose how long it would take to pay off the debt at only the minimum and also include how much it would cost monthly to repay within 3 years on each month's bill.

Although they now include 3-year payoff information on each bill, it is still deceptive. Anyone who has taken calculus (or just likes math enough) can probably figure out the obvious problem: as the balance decreases, the 3-year payoff amount also decreases and results in an almost perpetual 3-year window. So to actually pay it off in 3 years or less, you must keep those extra payments up at the level it shows on the current 3-year payoff quote.

However, overpaying your bill is not the only way to hasten the zero balance day. Recall from our discussion of interest that most every institution in the modern era computes interest based on an Average Daily Balance. Therefore, every day that the balance is up contributes to raising the average, even if you make substantial payments over when the bill is due and bring the balance down quite a bit. One trick that many have known for awhile and is somewhat popular in the mortgage world is to split the monthly payment in half and send that amount every two weeks, which is when lots of people get their paychecks. In addition to the advantage that is offered by lowering the ADB, it also results in sending an entire extra month's worth of payment every year. This is a powerful tool to use, especially at the beginning of a loan repayment period.

A similar situation exists on all other credit as well. While most of us probably view due dates with much dread and trepidation, waiting until it comes to pay the bill is a practice that is costing us money and complicates our lives. Akin to the biweekly payment, credit cards, car loans, student loans, etc. can garner savings by switching to paying the bill immediately after it gets calculated. That way, the ADB for the month is lower so a slight edge is gained on the interest charged.

Let's look at how it pans out at the four extremes of the balance-interest rate continuum. Under a high balance, low interest scenario (e.g. mortgage), there will be a noticeable positive effect, as in the case of paying off a mortgage early. A high balance, high interest situation will love this plan even more. A loan balance of $10000 with 30% APR will accrue $250 per month in interest. Making a $300 payment as immediately as possible will lower the the ADB down to $9700 for the rest of the cycle, saving $8 for the month--and all without having to give up any Starbucks! That $72/year may not seem like much, but it literally cuts two decades off the life of the loan. Rounding out the scenarios are the low balance, high interest and low balance, low interest realms. Due to the low balances, the savings aren't as impressive as in the first two areas, but are still real. The only exception is when the interest rate is lower than inflation. Overpaying one of those will actually cost money if the interest rate is lower than inflation.

But the advantages extend way beyond the pocketbook. By getting the payment taken care of ASAP, you lower the risk of running out of money to pay the bill later in the month and having to worry about not being able to pay it. You also lower costs associated with paying the bill itself. If your lender charges you to pay online, those fees can really add up quickly and so you probably mail in a check or money order to save money. Yet waiting until two days before the bill is due means you have to spend even more money on expedited delivery service to avoid a late charge. Add the stress of rushing to the Post Office while it's crowded and you will certainly feel beaten down. And that's before even considering your risk for something like a car accident or it being closed because of a holiday. Taking care of the bill much earlier in the month will lead you to rest easier knowing that at least one less thing to worry about.

More of my debts than not fall into the high balance, high rate area (or so it seems to me) and all are above the rate of inflation. As a result, I'm reorganizing my payment schedules so that I can pay my bills off as close to when they're calculated as possible. I've already detailed the possible savings, so that's plenty motivation for me. Anything to reduce the time it takes to eliminate my debt is good in my eyes and I can't think of many reasons why you shouldn't do what you can to do the same. The benefits to your wallet and general well-being are too great to miss.

No comments:

Post a Comment