Wednesday, July 11, 2007

Understand Your Interests

One of the interesting things that I've "figured out" over the past few months with regard to my debt repayment is the importance of paying early on daily compounded balances. I've been doing this myself over the past year and it really makes a difference.

The first question for all of your debts should be "how is the interest compounded?" For many debts, the interest is calculated each month on a monthly basis. For others, it is calculated up front for the life of the loan and then factored into your payments. Prepaying effectively does nothing to save you money on interest.

If however, you have credit cards, it is likely that you have a type of interest calculation that is called the average daily balance or two-cycle average daily balance method. If this is the case, paying off your balance earlier in the month can save you money.

This tip is not about paying extra principal per se, although you obviously should do that. Instead, the tip is about how you handle your cash flow. Let's say, for example, you normally pay your bills two or three times per month, lets say on the 10th, 20th, and 30th. And in this example, your monthly credit card bill is usually paid on the 30th of each month. If you pay it on the 20th of each month, you are saving yourself ten days worth of interest.

In a month situation where you carry a 5000 balance at 14% compounded daily and plan to pay down 500 dollars of principal, here's how that would help you:

If you wait the full month between payments, your interest will be 1/12 of the 14% of 5000, which is 58.33
Instead, if you wait only twenty days, your interest will only be about 1/18 of the 14% of 5000, which is 38.89.

That means that you are saving about 19.34 in interest by paying 10 days early. Of course, keeping that interest down makes sure that the next payment reduces the principal even further. Therefore, if you have money in your account, and plan on paying that credit card in a week or so anyway, just pay it now. You will really help yourself out with interest over the long haul.

The one caveat here is that you want to make sure that your payment is not TOO early. If it is too early, it will be considered a double payment. For example, if your payment due date is the 30th and you try to pay on the 5th, be careful. Depending on how your billing cycle runs, the payment may arrive so early that it is considered a second payment on the previous month. Then you may have to pay again in that month. And if you thought you paid, but you didn't, you will then be late and they will really get you with late fees and high interest default rates.

As always, I am not a financial adviser. If you have questions about your interest and payments you should contact your creditors and read your agreements in order to make sure you understand how this strategy might help you.

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