Get

Rich

Slow

Managing Debt

To get rich, you must first not be poor. I cannot simply advocate that you get out of debt. It makes more sense to suggest that you rearrange your debts so that you pay as little interest as possible. Also, you should make your interest tax deductible whenever you can. To help you do this, we will examine different types of loans and prioritize them.

Suppose you are faced with the following debts:

   Loan       Interest       Loan   Monthly   Net    Money
   type         rate  Years amount  payment monthly lost to
                                            payment interest

Credit Card      18%  27.5   1000      15      15      15
Personal loan    11%     5   5000     109     109      46
Car loan         10%     5   5000     106     106      42
2nd mortgage      9%   7.5  20000     306     276     108
1st mortgage      8%    25 100000     772     637     480
Total                      131000    1308    1144     691
 
                        Table 1

I list these debts from the highest interest rate to the lowest. The first mortgage has the lowest rate, because it is backed by the house. The second mortgage is backed by the house, only after the holder of the first mortgage gets his money from foreclosure. The car loan is backed by the car. The personal loan is backed by the honesty and integrity of the debtor. No wonder the interest rate is so high. Finally, the credit card rate is so high, because people do not shop around for good rates.

In looking at Table 1, focus on the total monthly payment and the money lost to interest. The money lost to interest is a total waste. We want to minimize this now and in the future. Fortunately, money lost to mortgage interest is partially reimbursed by the government (by 28% in this example). This is included in the calculation of the net monthly payment, the quantity you want to mininize so you can pay your other bills.

To continue this example, you look at your debt and decide that you can improve. You shop around and find out that you can get a credit card at a much lower rate. You get a card with a 12% rate and transfer your credit card debt to it. Your new debt situation is shown in Table 2 below.

   Loan       Interest       Loan   Monthly   Net    Money
   type         rate  Years amount  payment monthly lost to
                                            payment interest

Credit Card      12%  27.5   1000      10      10      10
Personal loan    11%     5   5000     109     109      46
Car loan         10%     5   5000     106     106      42
2nd mortgage      9%   7.5  20000     306     276     108
1st mortgage      8%    25 100000     772     637     480
Total                      131000    1304    1139     686

                        Table 2

You owe the same as before, but your net monthly payment is $5 less. Equally important, you now lose $5 less to interest. As good as this sounds, you just can't stand the idea of spending the next 27.5 years paying off your credit card debt. You decide to apply the $5 to paying it off faster. Table 3 shows your situation.

   Loan       Interest       Loan   Monthly   Net    Money
   type         rate  Years amount  payment monthly lost to
                                            payment interest
								
Credit Card      12%  9.08   1000      15      15      10
Personal loan    11%     5   5000     109     109      46
Car loan         10%     5   5000     106     106      42
2nd mortgage      9%   7.5  20000     306     276     108
1st mortgage      8%    25 100000     772     637     480
Total                      131000    1308    1144     686

                        Table 3

You are now on track to pay off your credit card debt in about nine years, with the same payments as when you started. However, you know you can do better. Why pay 12% when you can pay just 11%? You refinance your personal loan to include the credit card debt, as shown in Table 4.

   Loan       Interest       Loan   Monthly   Net    Money
   type         rate  Years amount  payment monthly lost to
                                            payment interest
								
Personal loan    11%     5   6000     130     130      55
Car loan         10%     5   5000     106     106      42
2nd mortgage      9%   7.5  20000     306     276     108
1st mortgage      8%    25 100000     772     637     480
Total                      131000    1315    1150     685

                        Table 4

Your payments are now slightly higher, because what was your credit card debt will now be paid in five years. More important, your money lost to interest is less. You decide to continue that pattern. You refinance the car loan to contain the personal loan debt, as in Table 5.

   Loan       Interest       Loan   Monthly   Net    Money
   type         rate  Years amount  payment monthly lost to
                                            payment interest
								
Car loan         10%     5  11000     234     234      92
2nd mortgage      9%   7.5  20000     306     276     108
1st mortgage      8%    25 100000     772     637     480
Total                      131000    1312    1147     680

                        Table 5

This time your monthly payment goes down, and you are losing less money to interest. You start to notice that the monthly payment exceeds the net monthly payment only for mortgages. You take advantage of this by converting the car loan into a third mortgage, as shown in Table 6.

   Loan       Interest       Loan   Monthly   Net    Money
   type         rate  Years amount  payment monthly lost to
                                            payment interest
								
3rd mortgage     10%     5  11000     234     215      66
2nd mortgage      9%   7.5  20000     306     276     108
1st mortgage      8%    25 100000     772     637     480
Total                      131000    1312    1129     654

                        Table 6

A third mortgage is risky, so its interest rate is as high as for the car loan. The monthly payment is the same but, thanks to the tax deduction, the net monthly payment is reduced by $18. Now you decide to consolidate the third mortgage into the second mortgage, as seen in Table 7.

   Loan       Interest       Loan   Monthly   Net    Money
   type         rate  Years amount  payment monthly lost to
                                            payment interest
								
2nd mortgage      9%   7.5  31000     475     428     167
1st mortgage      8%    25 100000     772     637     480
Total                      131000    1247    1065     647

                        Table 7

Even though the loan amount is higher, the second mortgage has the same rate. As a result, the total money lost to interest lessens. The monthly payment decreases, because what was the third mortgage is for 7.5 years now. At this point, you make your boldest move yet. You not only combine both mortgages into one, but you save so much money this way that you choose a 15 year loan. This allows for a lower rate and you save even more. See the very short Table 8.

   Loan       Interest       Loan   Monthly   Net    Money
   type         rate  Years amount  payment monthly lost to
                                            payment interest
								
1st mortgage    7.5%    15 131000    1214    1049     590
 
                        Table 8

You now have one easy payment that is $100 less than the original payment. Also, in 15 years you will be free of debt. If you can get some more breaks, such as pay raises, you can pay off the mortgage faster. Once you do this, you will have a $1214 payment with no one to take the money except you. This is how to get rich slow!

The basic rule in this example is to get as much money as possible into the loan with the lowest after tax interest rate. If much of this is confusing, click on Interest Rates and you will learn the basics and even some mathematics on the subject of interest rates.

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