FOOL SCHOOL
The Cost Of Your Debt

December 4, 2002

By Jane Mack (TMFJane)

You may owe vast amounts of money to various people, or perhaps just a teeny weeny bit -– but, whatever the size, you are bound to be paying interest on it. Just about everyone charges interest on what they lend you and, occasionally, we need reminding about what 'interest' actually is.

I dare you to take a tenner out of your pocket and set fire to it!

Go on! Watch it burn.

And then do it to another tenner.

You didn't do it, did you?

I'm not surprised. The idea of watching 'real' money disappear, never to be seen again, is a tad disturbing. But it's what you're doing every time you only pay off the minimum on your credit or store card -- or whenever you make that monthly payment on your car loan. Part of your payment consists of the ashes of that tenner!

Are we beginning to get the point across?

There's no difference between burning a tenner and not seeking out the best price. Well, there is -- one requires direct action, the other only requires you to sit on your backside. And, if you do the latter, you'll just be burning up all those tenners and will get a reputation for being one of the best customers of all those financial institutions out there! In other words, a sucker!

If you look after the pennies, the pounds will look after themselves, and it's time to finally take that old proverb on board –- even if your mother has been spouting it at you ever since you were primary school!

While you almost certainly know what the interest rate is -- and while you know how much your repayments are each month -- do you really know how much you will be paying overall? A £10,000 car loan at a very reasonable 15% from a High Street bank over four years will cost an extra £3,360 in interest payments.

How long does it take you to earn £3,360? And what else could you do with that £3,360 in 4 years?

Just like in George Orwell's 1984, the Wise money-men confuse us with doublespeak. Credit is simply another word for debt.

But "credit" has good connotations: think of phrases like "to his/her credit...", or "creditable". It sounds like a good and reliable thing -- almost the complete opposite of "debt". As a thought-experiment, try substituting "debt" for "credit" wherever you see it today: "Debt card", "easy debt terms", "low-interest debt", "interest-free debt for 6 months" "Poor debt rating? Don't worry -- we can offer you debt today!" Do they still sound like attractive offers? Does "good credit rating" really mean very much more than "you are considered to be a reliable payer of interest"?

It's far too easy to borrow – by sticking something on the credit card -- and it's far too easy to not pay it off each month. In fact a recent poll conducted by The Motley Fool revealed that 61% of us are carrying some form of non-mortgage debt -- with quite a high proportion (18%) servicing debts of more than £10,000. So you're not alone!

Don't forget that the interest rate is also relevant when it comes to any savings you might have. If you've got any then use them to pay down your debts. If you're getting 7% interest on £1,000 of savings but you're paying a rate 19% on servicing a debt of £1,000, then you're losing out to the tune of 12%. You'll have gained £70 on your savings but paid £190 in interest on the debt -- giving you an overall loss of £120. Where's the sense in that?

Be realistic! Once you've got rid of the debts, you'll be able to start saving much bigger wodges of money to make up for the loss of your nest egg. In fact think about this:

"One thing you can do is to realise that by removing your debt you ARE, in fact investing. If the APR on your credit card is 10%, for example, you are getting a 10% p.a. return on any amount by which you reduce the outstanding balance. So, you are not just improving your position by the amount of reduction, but by that extra 10% as well! What's more, this fabulous rate of return is guaranteed, no matter what the share market does! A very Foolish investment." -- Kevingr

By all means, keep a very small sum for emergencies, but, otherwise, use your savings to pay off as much as possible. Every little helps, and the more effort you make now, the sooner you'll be sorted out and on the path to comparative riches.

For more on tackling debt see our Get Out Of Debt centre.