Sunday, March 1, 2009

Debt and Wealth: How is your money working?

One thing I’ve learned over the years is to ask better questions. Questions can be loaded: Does this dress make me look fat?

Some questions can be misleading: How much money do I save because it’s on sale?

Money related questions can be the trickiest, but also some of the most important. That’s why I’m taking the time to think some of these issues through via this blog: issues like debt and wealth.

Here's one thing I've discovered: Money works for you or for someone else -- it’s called interest. But money does it’s work in a subtle, almost hidden manner.

In a family budget, interest is a hidden cost. I’ve had a budget for years, and only just recently have I exposed this cost. Currently, I’m scheduled to pay over $50,000 in interest over the next 12 ½ years. (And I didn’t see that? Why not? It’s hidden in my car payment and my mortgage.)

That’s an example of money working for someone else. The bank lent me money, and I pay interest, lot’s of it. (And credit cards are worse, but they get almost no money in interest from me.)

I also have a 401k which should be working for me, but… that’s another slightly sad story. I also have a couple of CDs: that money is working for me. My CDs are earning interest and providing a financial cushion against the unexpected.

Now I’ve learned another way I can make my money work for me: it can retire debt.

Here’s some questions I asked and answered yesterday:

How much did that car really cost?
How much did the house really cost?

How much interest expense can I save by paying down my home loan?
How much interest expense can I save by paying down my car loan?

Using some free online pay-off calculators, I found the answers to these questions. As a result of this self-taught four hour learning session, I was able to plot a 5 ½ year course that will leave me debt-free while saving me about $30,000 in interest.

Paying off $1,000 dollars of debt earns me a $500 bonus. Wow. Who knew?

Some argue against paying off a mortgage for tax reasons, but consider this counter-argument from Crown Financial Ministries:

"The great 19th-century British author Charles Dickens said, “It has been my experience that if a thing sounds too good to be true, likely it is.” In the case of mortgage interest deduction, Mr. Dickens’ admonishment may need to be heeded.

A home mortgage interest deduction is often misunderstood. In order to recoup all of the interest paid on a mortgage, a person would have to be in the 100 percent tax bracket. However, most people pay around 30 percent of their income in taxes. Therefore, the IRS deduction they receive is 30 percent of the interest paid on the mortgage.

As an example (remembering that the tax rates are graduated and based on a lower or no percentage at lower incomes), assume that a person is in a 30 percent federal tax bracket and a 6 percent state tax bracket. That means for each $1,000 in interest paid on a home mortgage, 30 percent or $300 of the interest paid could be received back from the IRS and 6 percent or $60 could be received back from the state. This would net the taxpayer $360 from the federal and state governments for the $1,000 interest payment.

But, wait a minute – what happened to the other $640 you paid in interest? Well, of course, the mortgage company kept the $640.

Consider what would happen if a homeowner simply paid the taxes instead of paying interest on a mortgage; the owner would owe $360 in federal and state income taxes but would keep $640. Get the picture?

Most Americans accept long-term debt on their homes as normal. Understandably, with the prices of homes being what they are today, most couples need extended loans to lower their monthly payments initially when buying a house – nothing wrong with that.

However, couples could pay their homes off in 10 to 15 years if they would simply control their lifestyles and prepay their mortgage principal a little bit each month. Then, when they have no mortgage, they might have to pay some additional taxes, but the point is that they also get to keep what they would have had to pay to the mortgage lender."

So if retiring debt is such a good thing, how can I do it? (Crown Financial Ministries helped me again. Isn’t it amazing: The things you can learn if you can read, digest, and apply.)

Retire the debt

"Pay extra on the debts with the highest interest rates. If all interest rates are comparable, begin paying extra on the smallest balance. After that debt has been paid, apply the regular payment as well as the extra money that was going to it toward the next highest balance. After the second is paid off, then the third highest and so forth."

I didn’t get this method at first, but as I pondered it, I began to understand the power.

I have only a car loan and a house loan. If I make budget adjustments to pay those two bills plus something extra each month, once the car is paid off, I keep making the “car payment” but now it’s used to pay down the mortgage. My 13-year house loan thus becomes a 5 ½ year loan (via a fairly substantial “something extra” each month).

A bit over two years ago, my youngest daughter transferred to a University: tuition cost from Dad -- $500 a month. (I hadn’t saved for her college, she hadn’t either. I had income, she has loans.) But she’s graduated and I’ve got $500 extra in my budget, plus I got a small raise at work. There’s that something extra!

By retiring the debt, I’m building equity/wealth in the car and more so in the house. If, when I retire, I sell and move elsewhere, I could conceivably get back all I’ve paid in principal and interest on the house. That’s where the building wealth comes in.

I’m on step four or five of reducing debt and building wealth: goals, a budget, household agreement, emergency funds, most of these are already in place. I’ve done a lot towards creating fiscal balance, but now I can see my way clearly to move more intelligently towards retirement. One part of the puzzle is “simple: I'm reducing debt and building wealth.

If you made it to the end of this post, I applaud you. You must really want to get a grip on your finances and move more intelligently into the future.

This post represents my musings these days: financial, practical, and empowering. I hope my musings get you thinking.

No comments:

Post a Comment