Category Archives: Debts

The Minimum Monthly Payment Trap 2!

In my last post, I told you two ways your loan balance can continue to increase.

Even when you are making your minimum monthly payments, 

  • if you miss your minimum monthly payment, and/or
  • whenever you are allowed to pay less than your minimum monthly payment
    • your loan balance may continue to increase.
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Other scenarios in which your loan balance will continue to rise:

A ‘debt relief’ program promises you can make ‘smaller payments’

  • than the standard/reasonable minimum monthly payments, and
  • used by some unscrupulous lenders to trap you
    • into perpetual debt.
  • Some government and/or education loans repayment plan are also
    • income driven, i.e. based on
      • how much you earn not
      • how much is required to pay off the loan
        • in a reasonable period of time.
  • Example 1: you owe $25,000, at 15% annual interest rate computed on the balance each month
    • The minimum payment is 2% or $500.
      • “That’s too high”,  you say,  “can you help me?”
      • “Can I pay $200 per month please?”
      • Sure”, the lender says, “just for you!”
      • What you may not realize is that
        • $200 does not cover your monthly interest ($314).s
        • The difference ($314 – $200)
          • is added to your loan balance
          • (the interest has been ‘capitalized’)
            • which continues to earn interest.
  • Example 2: The Education Department Income Driven Repayment Plan (IDRP)
    • provides relief to people allowing them to make payments
      • based on how much they earn
      • on loan balances that earn interest each day
        • until the to total balance is paid off.
    • As above, you may be making all regular required payments
      • but your actual loan balance could be increasing!!

You make regular minimum payments but

  • if the interest rate is high and if
  • the loan balance is continually earning interest,
    • your loan balance will continue to increase; in fact
    • the loan balance will double approximately
      • every 70/(interest rate) years
        • according to the ‘Rule of 70’:
          • an amount that grows at the rate of ‘x’ per period
            • will double approximately every 70/x periods.
      • Example, a credit card balance of $25,000 at 15% annual interest rate
        • will double every 70/15 = 4.7 years (4 years and 8 months)
        • If you make every minimum required payment of 2%,
          • The balance will double every 70/13 = 5 years and 5 months.

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Note: 

  • Some credit card loans will have lower/higher interest rates.
  • Some loans (some mortgages, car notes)
    • have interest calculated over the life of the loan.

Final Take Away

  • If possible, avoid loans
    • for which the interest rate is calculated frequently
      • on the outstanding balance.
  • Make sure your minimum payments at least cover your interest
    • in each period.
  • Make sure your minimum payments covers some of your principal each time
    • If not the make additional payment to cover
      • paying down your principal.

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You Can Do It!  Let’s Do This!!

The Minimum Monthly Payment Trap!!

As a general principle, debt is bad unless

  • It’s an investment debt, examples of which are,
    • education loans in an area and, in an amount that makes economic sense
    • a mortgage,
      • a loan to purchase a house or real estate,
        • for which at least you have a real asset to sell off later,
        • it can be viewed as a form of saving at the least;
        • you may be able to build equity over time, and thereby
        • to increase your net assets position; or
    • an asset that will produce returns
      • greater than the cost of servicing the debt,
        • i.e. your earnings on the asset is greater than interest paid on it;
      • for example, a business or some form of an investment instrument
        • that produces an additional and an ongoing stream of income.

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Long Term Loans,

  • credit cards, education loans, business loans, mortgage loans etc.
  • even for ‘good investment loans’ (debt) have one trap:
    • the ‘Minimum Monthly Payments’ trap.
  • ‘Minimum Monthly Payment,’
    • is the amount you are required to pay on your outstanding balance
      • at regular periods (usually monthly, but also quarterly, yearly, etc.)
      • over the life of the loan;
      • meant to at least cover the interest on the loan.
    • But it may not cover your total monthly interest,
      • which means the amount you owe could be increasing
        • even while you are making regular payments!
  • When you take out a loan, your loan balance
    • which is your total debt on the loan,
    • continues to earn interest,
      • by the day, month, etc. depending on the loan details; it may also
    • increase when you fail to make a payment
      • because you get charged a penalty for late or non-payment,
        • which is then added to your loan balance!

 If your minimum payments do not cover the interest,

    • in each period,
    • the unpaid interest is usually added to your outstanding balance
      • (this is called ‘capitalization’ of the interest)
      • that is, it’s like you took a larger loan in the first place;
    • future interest payments may be calculated on
      • the unpaid interest plus the original balance (‘principal’);
      • which is now the new and higher ‘principal’,
      • therefore your debt is growing, even as you are making
        • regular payments towards it!
  • Example, say you hold a balance of $25,000 on a credit card/loan
    • at 15% annual interest rate computed on each month’s balance, you must pay
      • $3750 per year in interest (25,000 x 0.15) or
      • $308 – $312 per month (3750 /365 * 30 days; or $3750 /12 months) or
      • $500 per month if the minimum payment required is 2%
        • ($25,000 * 0.15)
    • If you miss one minimum payment,
      • the $500 may be added to your balance of $25,000
        • at the end of the period
        • to become $25,500.
        • Your annual interest at 15% is now
          • $3825 per year (25,500 * 0.15) or
          • $314 – $318 per month (3825 /365 * 30 days; or $3825/12 months) or
          • $510 per month if the minimum payment required is 2%
      • Additional fees (penalties) may also be added to your loan balance.
    • If on the other hand
      • you are in financial difficulty and ask for reduced payment
        • that is less than your interest payments,
          • say you want to make a $100 payment,
          • instead of the minimum payment of $500
        • you will be paying less than the interest payment
          • (of $308 – $312 per month);
        • your outstanding interest may be capitalized
          • i.e. added to the initial balance of $25,000:
          • which is $208 – $212: the difference
            • between your monthly interest
              • ($308 – $312) and
              • the $100 you paid
          • will be added to your balance;
          • other ‘late penalty’ or ‘non-payment’ fees
            • may also be added to your balance
          • other ‘finance’ or ‘financing’ charges
            • may be added to your balance and
          • the total loan balance will increase.
        • Then what looks like a relief (less than the minimum payment)
          • turns out to be bad for you in the long run

There’s more. Check back tomorrow!

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