Debt Financial Wisdom
By having financial wisdom and a deep understanding of how lending practices work, you can leverage this knowledge when it comes to planning a debt freedom strategy.
Lenders loan money to make more money. The increased money that lenders earn, for the most part, comes from interest revenues and activity fees collected from borrowers. To monitor borrower’s behavior, lenders track the smallest details of the loan approval and repayment activities. They also use these procedures to determine the classification of a borrower in their records, as either good stewards or bad stewards.
By using financial wisdom, we can develop a game plan that counteracts the income incentive of lenders. Every dollar that does not go into the lender’s pocket as interest and fees remain in the borrower’s pocket as cost savings.
Why It’s So Stressful Getting Out of Debt
Have you ever wondered why it so easy to get into debt, but so difficult to get out? Make no mistake about it; long payoff periods do not occur haphazardly. Lenders design their loan approval processes and repayment schedules that way.
For example, department stores routinely lure shoppers into debt by offering special discounts at the register for signing up for a new credit card. Credit card companies and other lenders send flashy direct mail offers that have low teaser interest rates or other special rewards. Each of these strategies is designed specifically to entrap consumers into carrying heavier debt loads for longer periods of time.
Once approved for the credit card, you can then expect to see advertisements for the specific goods and services you generally purchase. Why? Because the lenders are tracking your behavior and spending patterns. These ads are designed to entice you to spend more, and they love it when you spend more with their credit card.
Consumer Purchase Behaviors
Research shows that consumers who use credit cards generally purchase more. Lenders also know that most consumers desire to have low monthly payments, and they are more than happy to accommodate. Lower monthly payments mean more interest income for the lender, for longer time periods.
High-Interest Rate Financial Wisdom
Charging high-interest rates is another weapon used by lenders to make it difficult for consumers to get out of debt. Each monthly loan payment consists of two components: interest and principal. Although the minimum monthly payment amount remains the same, the allocation between interest and principal amounts varies in direct proportion to each other.
In the early stages of paying off a loan, payments against high-interest rate loans have only a small portion of the monthly payment attributed to principal. Only the principal portion of a payment is used to reduce the loan’s balance.
Let’s assume a person borrows $3,000, at an annual interest rate of 24% that has a minimum monthly payment of $75. To calculate the interest portion of the monthly payment, multiply the loan balance of $3,000 times 0.24 (the decimal representation of 24%). The result of this calculation is $720 per year. To determine the monthly amount, divide $720 by 12 months; the result is $60.
Now remember, out of each monthly payment, interest cost is paid first. The remaining portion then applies to the principal to reduce the loan balance. In our example, to calculate the principal amount, subtract the $60 interest cost from the $75 monthly payment. The result is $15 designated as principal.
How to Calculate Loan Data
Loan Details:
Borrow $3,000 at an annual percentage rate of 24%. The monthly payment is $75 per month.
Are you surprised? Of the $75 monthly payment, $60 is interest cost, and only $15 goes towards to principal. Remember, only principal payments reduce loan balances.
After making the $75 monthly payment, the remaining loan balance drops to $2,985, which is calculated by subtracting the $15 principal payment from the initial $3,000 loan balance.
By making timely payments for the duration of this loan, it will take approximately six years and nine months to pay back the $3,000 borrowed. During that same period, the borrower pays $3,093 in interest cost.
This simple real-life example demonstrates why it takes so long to become debt-free. The setting of interest rates and monthly payments is just one tactic lenders use to keep us bound. We'll discuss more tactics in the next post.