Sunday, November 9, 2008

Daily Interest & Motivation

What does a 14% interest rate on a $3,000 credit card balance really mean?
What does a 6% rate on $22,000 car loan balance really mean?

Sometimes, to fully understand the impact that debt can have on your life, you need to break it down into more meaningful chunks. For me, breaking down that interest cost to an estimated daily amount was very beneficial and eye-opening!

Let's say you have a credit card with a $3,000 balance and an interest rate of 13.99%. We can get a decent estimate the your daily interest rate by merely dividing your interest rate by 365 (days in a year).

13.99% / 365 = 0.0383% per day

Now, that 0.0383% sure doesn't sound like much, but when you multiply by your balance:

0.0383% * $3,000 = $1.15 per day!

By itself, you may say "it's only a little over a dollar a day!", but think of it this way: that's a $1.15 every day, whether you work all day, sleep all day, go on vacation, whatever. EVERY DAY. How would you feel if you woke up every morning and as soon as you walked out the front door, somebody would hold out their hand and demand $1.15? I'd get sick of that pretty fast! But, that's exactly what you're doing, just in a more deceptive way.

Want an even more extreme example?

Let's say you bought a shiny new car last year and owe $22,000 at 8.5% interest. I'll do the math again:

8.5% / 365 = 0.0178% per day

0.0178% * $22,000 = $5.12 per day!

In other words, you're forking over a Lincoln every single day just for interest on that loan! $5.12 a day would pay for my lunch every day!

Fortunately, every payment you make drops that daily interest down a bit more. Making extra payments on the principle drops it even faster.

As you can see, it wouldn't take long for your daily interest to add up to $10, $15, or even $20 a day. Couldn't you use an extra $10 a day?



SpedDoc said...

Dear YFNN:
I agree that understanding interest rates on unsecured debt is important, but aren't there some instances when paying off the debt is not such a great idea? Student loans for example? Can't I make more from my money by keeping it in an interest-bearing account since my student loans sit at about 2.8% and just make minimum payments? Or if you have one of those credit card accounts where the rate is 2-3% for the life of the rolled-over debt transfer?

Your Friendly Neighborhood Nerd said...

Since savings rates are so low right now, there's not too many debts right now that are beneficial to not pay off. ING Direct is currently paying just 2.75% and my money market account is only 1.8% or so. If you've got a debt with a lower interest rate than that, it MAY make sense to save rather than pay. But, you need to also keep in mind how taxes factor in. Since interest paid in a savings account (or money market or whatever) is taxed at your normal income tax rate, you've gotta knock off about 25% of the gain for that. That drops ING's 2.75% rate to a realized rate of about 2.0%.

This can work the opposite direction, too. Student loan interest is typically tax-deductible, so your realized interest rate there is actually a bit lower, too, which helps you out.

Personally though, I think it's mostly inconsequential unless you're talking tens of thousands of dollars. If it's close at all, I lean toward ditching the debt (assuming you've got SOMETHING in savings).