The Cost of Debt: Doing the Math

No man’s credit is as good as his money.

~ E.W. Howe

Update: This post is included in the March 1st, 2010 Carnival of Debt Reduction. Thank you!

When we take on debt, we’re essentially borrowing from our future earnings in order to have the things we want right now. There’s a cost for that. It’s called interest and it can exact quite a toll on the balance sheet. I’m always writing about how you need to do the math in order to make good financial decisions, so I thought I would give a few examples here of how much various types of debt can cost over time.

In general, there are 3 main types of personal debt that we tend to incur: mortgage, vehicle, and credit card loans. Each carries with it a unique cost structure that’s worth looking at. The chart below provides some sample calculations for each of the three kinds of personal debt. I tried to change only one factor at a time so that you could easily draw some comparisons.

The car loan section was difficult, as financing rates can vary widely from 0% to 5% or even higher depending on where you’re getting the financing. I chose 1% and 3% almost arbitrarily after looking at a couple of websites. The cost of financing a car isn’t all that onerous at those rates, but if rates rise, the picture changes a lot.

To do the mortgage and the car loan calculations I used the Canadian calculators at dinkytown.com. For the credit card calculations, I used the excellent calculator provided by the FCAC on their website. In addition to the links in this post, you can always find these calculators in the “Resources” links on the right side of the page.

The Cost of Debt

Those credit card figures are not typos. Making minimum payments only is extremely expensive. If you play around with the FCAC calculator, you’ll notice that paying even a small amount above your minimum can make a huge difference in the time it takes to pay off your balance and in the amount of interest that you’ll pay.

For example, if you have $5000 in credit card debt and you pay an extra $10 a month above your minimum, you’ll save $6550 in interest and shave 25 years and 1 month off your payment time. If you make fixed payments of $150 a month instead of the minimum, you can save $12 165 in interest and pay off your balance 40 years and 2 months sooner.

Of course, the ideal way to handle it would be to pay off your balance in full each month, thereby incurring zero interest charges. That way, you will put yourself in a position to save money for your future rather than taking it away from your future earnings. One take-away from this chart is that if you must take on debt, try to borrow from any source other than a credit card company. Most banks will offer lines of credit that are much cheaper.

If your eyes didn’t glaze over at the sight of so many numbers, did you find anything interesting or surprising here?