Debt Interest: The Silent Killer
After a recent podcast episode, a listener asked me to expound on debt’s “silent assassination technique.” Debt is not a cobra that unexpectedly strikes from the undergrowth. It’s a python you stupidly take out of the cage and allow to slither around your torso until you suddenly realize it’s squeezing harder than you can handle.
In this post, you’ll find some simple math to show you how stifling debt interest can be.
Of course, we need a disclaimer. Not all loans are the same. Some loans are perfectly acceptable to hold on your balance sheet. Namely, loans with low interest rates and, ideally, reasonable principal amounts. But what’s “low” and what’s “high” in this context? We’ll get into that.
And a second disclaimer: debt can be a wonderful tool, for both personal and investment reasons. Debt isn’t evil. But, as we’ll see below, it needs to be well understood if you plan on using it.
Let’s dive into some fun numbers.
First, we’ll examine this reasonable modern-day American mortgage.
- 30-year term
- 7.0% interest rate
- $300,000 principal amount
A simple mortgage calculator or spreadsheet will show you that the monthly payment on this loan is $1996 per month.
But here’s the important part: during the early years of this particular mortgage, only ~12% of each monthly payment pays down the principal. The other 88% (or $1750 per month) staves off the relentless tide of interest. That is “wasted” Money.
It’s not so bad to be a lender. Your pay starts on Day 1, when most of the borrower’s payments are interest directly to you.
Back to being the borrower…Fast-forward to Year 5— have made $119,000 in total payments, only $17,000 of which paid down principal. By Year 15, that ratio is $360,000 in total payments, of which $78,000 has paid down loan principal.
Just look at the graph below: when the red Payment line and the green Interest are close to one another, that’s equivalent to, “Almost all of your payments are paying off interest.”
The early stages of loan payback are when the lender receives the most interest and when the borrower pays back the least principal. This is true for all loans at all interest rates but becomes more severe with longer loans and higher rates. This is how debt pulls off its sneaky attack against your personal finances.
Interest rates are vital. As a quick example, let’s examine the same loan as before, except we’ll change the interest rate to 3%. Some quick results are:
- The monthly payment drops to $1265 per month
- During the early months, ~41% of that payment pays down the principal (much better than 12%!!!)
- By Year 5, you’d have made $76,000 in total payments, $33,000 of which paid down principal
- By Year 15, that ratio is $228,000 in total payments and $117,000 in principal
Much better ratios! Lower interest rates make debt much more palatable. The graph below looks much more acceptable!
I want to share one last example with you.
We will take our first loan (@ 7%) and pretend that we re-Finance it down to 5%. We could decrease our monthly payments now that we’ve secured a lower interest rate. But instead, we’ll keep our monthly payments the same in an effort to kneecap interest’s silent assassination technique. How will our ratios change?
- We intentionally keep our monthly payment at $1996 per month
- During the early months, 37% of our payment goes to principal repayment (as opposed to 12% before)
- By Year 5, 48% of our payment is going to principal. In sum, we’ve made $120,000 in total payments, $51,000 of which went to the principal.
- By Year 15, the ratio is $359,000 in total payments and $199,000 in principal.
Let’s fast-forward to the end of the loan. We repay the loan in Year 20 (a full 10 years ahead of schedule!)… look at the graph below.
We pay $172,000 in interest payments over those 20 years. The original loan schedule at 7% interest had $418,000 in interest payments over 30 years.
Yes – from $418K in total interest down to $172K in total interest. A quarter million in interest saved! It’s important to understand how your specific debt(s) are affected by interest rates and payment schedules.
But don’t get too excited. We must consider opportunity costs. You could pay down your 2.75% mortgage and save plenty of interest payments. But even a conservative investment allocation will likely grow much faster than 2.75%. Even high-yield savings and money markets are 4% to 5% as of this writing. You’d rather grow at 5% than prevent interest at 3%. That’s simple financial math.
But when we have loans at 6%, 7%, or higher, my personal calculus changes. By making extra debt payments on a 7% loan, I guarantee that return on investment. “Guarantee” is a special word in financial planning.
Usually, we sacrifice returns to secure a guarantee. E.g. – high-yield banks or money market funds are guaranteeing 4-5% returns right now, much less than the possible (but risky) returns from the stock market.
Would I rather have a guaranteed 7% return, or take my chances in the S&P 500? This is partially an asset allocation question. I already have lots of exposure to the stock market via my Retirement accounts. So when it comes to the home my family lives in, I’ll take a guaranteed 7% return while also lightening the overall debt load.
I’ve even put my money where my mouth is. In addition to our regular monthly mortgage payments, we also made an extra $5000 principal payment this year. By the end of the mortgage term, that extra $5000 will have shaved off 12 months of normal payments and saved $30,000 in interest.
From a pure Investing point of view, the question is: would you lock away $5,000 today to guarantee $30,000 in 29 years?
Some would say yes, others might say no. Personally, is see that as a fixed income allocation that I’m happy to add to my overall allocation.
But anyway…back to the main topic. Debt interest is a drag. Worse, many of us aren’t fully aware of just how nasty that drag affects our financial plan. You need to understand:
- What debt, if any, is on your personal balance sheet?
- What’s the principal amount(s)?
- What’s the interest rate(s)?
- And when you have “extra dollars” in hand, will you be best served by paying down that debt ahead of schedule, thus ending the interest payments far sooner than expected?
Thank you for reading! If you enjoyed this article, join 8500+ subscribers who read my 2-minute weekly email, where I send you links to the smartest financial content I find online every week. You can read past newsletters before signing up.
-Jesse
Want to learn more about The Best Interest’s back story? Read here.
Looking for a great personal finance book, podcast, or other recommendation? Check out my favorites.
Was this post worth sharing? Click the buttons below to share!
