Money in a piggy bank is simply hoarding – not particularly useful for building wealth. Simple interest provides a fixed return on a given investment. This is better, since your money earns something. The sexiest of options, though, is compounded interest.
Compounding is what can make CDs, money markets, bonds, and reinvested stock and mutual fund dividends very powerful tools for building wealth over time. Investopedia created a short, clear video that intuitively explains the beauty of compounding.
Credit Cards: Compounding Misery
Compound interest is Dr. Jekyll in your savings and stock accounts, but Mr. Hyde when it comes to credit cards. The same power of interest building on itself can skyrocket your credit card debt rather swiftly.
When a person dips their toe into their first unpaid balance on a credit card, it doesn’t seem like a big deal. The shortage is usually for a good(ish) reason and the interest to be paid seems quite manageable. But, if the payments made each month aren’t covering the accrued interest, then the debt will compound. As the debt grows, so does the interest due each month. If you miss a payment, card companies may penalize you by raising your interest rates. Things can quickly get out of hand.
Even if you’re heading in the right direction and paying down the principal, you usually have to first pay off the accrued interest each month, leaving only a small fraction of your payment going toward paying down your initial debt. Hence, the sadly typical situation of a seemingly manageable credit card debt taking over 30 years to pay off when a person opts to only pay the minimum amount due. Not quite a fool’s errand, but certainly foolish.
Want to see how this works out in a numerical example? Check out the bottom half of this article.
Does this blog post get you down? Fret not! Sign up for Community Ladders – we’ll leave the light at the end of the tunnel on for you!
A Calculator and Critical Caveats
Our members already know that I don’t put a ton of faith in the savings and retirement calculators strewn all over the internet. They are certainly useful, and have their place in planning. However, many of their default assumptions (like expected annual returns of 8-10%) are overly optimistic and most lack the ability to give various scenarios based on different rates of inflation. This means they don’t give you an expected range of your future purchasing power in terms you can relate to—the value of a dollar today.
A realistic calculator is rather complex to use. Instead, we suggest using a basic calculator that has appropriate default return assumptions. This can still illustrate how increasing your savings rate—even by just one percent—can grow over time using the power of compounding. Just realize that a dollar many years out is worth significantly less than a dollar today. Happy Compounding!
I posted this comment on Mint’s blog asking about people’s opinion on borrowing from family and friends:
We deal with this question a lot at Community Ladders, since we work with many young professionals just starting out who lack a strong credit history or who are pursuing jobs on Capitol Hill and in the non-profit sector that don’t pay well initially.
As a rule of thumb, borrowing from family is best avoided, but sometimes it can be a compelling option for both parties during this time of low-yield savings accounts.
However, I have our members write out formal loan contracts with loan repayment rates, timelines, total payout, and interest (I think one should ALWAYS pay some interest, typically around 2 to 5 percent). Sometimes we’ll even put in penalties in the case of missed payments, or build in a number of ‘grace months’ where a payment can be skipped without penalty. We also usually have a clause that if the lender needs the money back immediately, the borrower has 60 days to find another source and pay back the outstanding balance in full.
The important thing is to be explicit and set clear expectations for repayment (and then, of course, stick with it). As long as you are repaying the loan on schedule, your family shouldn’t be all in-your-business about what you are spending your money on.
This is certainly awkward to set up initially (our members get to blame it on me, since I often draw up the agreement for them and am rather insistent that they use such a contract), but trust us that it saves a lot of awkwardness, misunderstanding, and anger down the road.
| May was an exciting month! Bill Varettoni presented two free seminars on financial planning for graduate students at the University of Maryland. The seminars were very well received, and people even laughed at his finance jokes!
We also donated 16 hours of consulting services (valued at over $1,500) to auctions held by All Souls Unitarian Church and E.L. Haynes Public Charter School in Washington, D.C. Community Ladders is proud to support organizations that foster stronger communities. |
Bearing the Burden of Loan Payback
Working with our members, I absolutely love when people come to see me and they’re serious about paying down debt, and are doing it. In isolation, paying down debt is almost always smart. But, things are not so black and white when you have to plan over time. For instance, I’ve seen a number of members who are aggressively paying down student loan debt. While they’ve made significant progress, now they’re thinking about buying a home and have little saved by way of down payment. Paying off student loans only to turn around and need to borrow the same money again seldom makes sense.
Here are some reasons we like student loan debt (assuming you must have debt):
Interest is Tax Deductible – Up to $2500 is deductible if your modified adjusted gross income is less than $75,000 ($150,000 for joint filers). This is always deductible, regardless of whether you take the itemized or standard deduction on your taxes.
Source: IRS
Lower interest rates – Student loan debt often (but not always) comes with lower interest rates than many young professionals can get on new debt, especially if you have a weak credit history.
Loan Forgiveness – If you qualify for repayments based on income (payments are generally 15% of your discretionary income), you may be eligible to have your federally-backed student loan debt forgiven after 25 years. If you’re in public service (such as government and certain non-profits), it may be forgiven after 10 years. I often caution our members not to rely totally on loan forgiveness, as it’s an expensive government program that isn’t guaranteed to exist in the future. You also need to have a career that pays low enough that you continue to qualify for income-based repayment.
Source: Government loan website
You can’t borrow money for a house down payment – While paying off your student debt early can feel awesome, you may find yourself in a situation where you want to buy a house. You can’t borrow money for a down payment, and your dutiful early repayment of your student loans won’t help you over this hump.
A number of repayment options – Federally-backed student loans offer a number of repayment options, including plans scaled to income, graduated repayments, and different timelines. See an authoritative description of loan repayments.
This isn’t a recommendation to take out more student loans because they’ve got a lot of sex appeal as far as debt goes. All I’m suggesting is that we view student loans in light of your broader financial picture. The pay-down-debt dogma is a good one, but not always optimal.
More Student Loans May be a Good Idea
Community Ladders has made a concerted effort to reach out to students (undergraduate and graduate) while they’re still in school. Two of the main things we focus on are building up credit scores and planning for expenses (including additional debt) in the years following graduation. I’ve seen a lot of students graduate having not thought about credit scores (or much else in terms of finances), and then immediately get a car loan or continue to pay interest on outstanding credit card debt.
As a planner, I often find this makes little sense, especially for those students who passed up subsidized loans during their final years in school. To be clear, legally student loans should only be used for education expenses, but planning your transition in the last year of school is part of that educational process. If you’re going to need to take on debt immediately after university, student loans may be a better way to finance those needs. This is especially true if you’ve had a rough credit history. See our adjacent blog post for the number of benefits that make student loans … well … special.
Critical Note: There are a lot of moving parts in the calculation about whether more student debt makes sense. This is not a recommendation. In fact, I only recommend this to a very small minority of our membership. For the majority, it doesn’t make fiscal sense. My point here, though, is that our instinct is to shun debt until we are desperate for it, and that’s not always the smartest play.
Two-thirds of bachelor’s degree recipients graduated with debt in 2008, compared with less than half in 1993. Ouch. In fact, one authority on the subject said, “in the coming years, a lot of people will still be paying off their student loans when it’s time for their kids to go to college.”
Nevertheless, 2008 bachelor’s degree recipients’ median earnings were about $22,000 more than high school graduates, and their unemployment rate was far lower. The investment can clearly pay off over the long haul, but it’s far more painful a burden than in years past.
One thing is for certain, before taking on the debt load, students need to make sure they are committed to making their education pay off. Unlike most other debt, student loans generally cannot be discharged in bankruptcy, and the government can garnish wages or take tax refunds or Social Security payments to recover the money owed. They do have other perks, though, as covered in our adjacent blog post.
And be wary that the degree you’re obtaining will really open the doors you’ll need to get past that pile of debt. Tragically, students who borrow to attend for-profit colleges are much more likely to default. Many experts point to the lack of weight those degrees carry with potential employers as a significant factor. While they make up only 12 percent of total enrolled students, they account for nearly half of those defaulting on loans.
Source: New York Times
Community Ladders is auctioning off 6 hours of financial consulting services (valued at $570) to benefit programs at E.L. Haynes Public Charter School in D.C.
The auction is private and limited only to E.L. Haynes’ families, staff, and community.
Community Ladders is auctioning up to $1000 worth of services as part of All Souls Unitarian Church’s (Columbia Heights, DC) annual auction. Bidding is for 2-hour consultations.
Multiple sessions are being auctioned throughout this week – online through Wednesday and then live on Saturday.
Bid early and often!