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October 31, 2019

Compounding Debt: The Dark Side of Compounding Interest

Compounding interest can be a powerful tool to have in your arsenal. It can be very beneficial and create large sums of money over time if wielded correctly. But unfortunately, there is a darker side to compounding interest – compounding debt.

Interest Goes Both Ways

In a previous post, we discussed how compound interest can be used with reinvested returns to create massive growth.

When you’re earning interest, your money grows and multiplies as your little green employees work hard day and night.

This happens when you invest in a company or make a deposit in a bank, for example. In these cases, the company and the bank are indebted to you so you earn the interest.

The problem is when it’s you that gets into debt. In this case, it’s you that incurs interest on what you owe. And if you don’t have a solid repayment plan, that can easily spiral out of control.

The Hole You Dig Yourself Into

Debt is rampant across the United States. According to the New York Federal Reserve, consumer debt was approaching $14-trillion in the third quarter of 2018. This includes mortgages ($9.14-trillion), auto loans ($1.65-trillion), student loans ($1.44-trillion), and credit card loans ($829-billion).    

Although clearly massive, these numbers don’t really look like they mean anything until you take it down to a personal level. If your household has a mortgage, auto loans, student loans, and credit card loans, and you have trouble making payments and even miss a few, you can easily dig yourself into a hole that you’ll be hard-pressed to get out of.

Let’s play out a couple of scenarios.

Mortgage

We’ve all heard the advice of, “buy as much house as you can afford.” Unfortunately, that also means maxing out the mortgage you can pay each month. Instead of buying a reasonably-sized house, you buy the 5,000 square foot McMansion.

You might say, “Yeah, but my mortgage payments are only 20% of my income. Interest rates on home loans are so low!”

But what would happen if you lose your job? Or even worse, what if mortgage rates suddenly rise?

Suddenly that payment takes a larger chunk of your income to rates you can’t afford and you foreclose on your house.

Payday Loans

These are small, short term loans that were designed around the average payday schedule. Taking out loans like these are an option for people who need quick cash or have a bad credit history.

It’s a massive $90-billion industry with interest rates that can also be equally as massive. Annualized, these can reach highs of 150% to more than 500%.

Let’s give a simplified example.

Here’s what a 12 month period looks like if the payment schedule was followed.

Notice that the amount of interest paid is huge, and this is excluding miscellaneous fees like loan establishment fees.

Now, here’s what happens after missing just one payment.

Suddenly you’re stuck in debt.

Subprime Crisis to Global Meltdown 

What happens when millions of people across the U.S. default on their mortgages? We found that out the hard way in the financial crisis of 2007.

Subprime mortgages are loans given to people who have difficulty making regular payments. Borrowers were encouraged by loan incentives and a long term trend of rising housing prices which led them to take risky loans.

The subprime mortgage crisis “was triggered by a large decline in home prices after the collapse of a housing bubble, leading to mortgage delinquencies and foreclosures and the devaluation of housing-related securities.” This led to an international banking crisis which resulted in the Great Recession. 

When compounding debt hits you, it can hit hard. When it hits the largest economy in the world, everybody suffers. 

Freedom from Compounding Debt

If you’re stuck in the vicious circle of compounding debt, here are a few ways to be free.

Kill That Debt

Quickly get out as fast as you can. The less you owe the less interest you incur so pay as much as you can as often as you can.

 A couple of popular strategies are the debt avalanche and the debt snowball methods.

Consider a More Frugal Lifestyle

Oftentimes people get into debt because of the desire for more. But what most people find out is that having stuff doesn’t equate to having happiness.

Having a frugal lifestyle means identifying the things in your life that can bring you true happiness and contentment. Simple strategies like the 555 rule can help you understand what’s really valuable by asking yourself how you feel about a purchase 5 days, 5 months, and 5 years from now.

Refinance

If you have a lot of debt from different lenders, you should consider refinancing or consolidating your loans by means of a balance transfer. This is a great strategy especially if you have some high-interest loans because debt consolidation offers often have a lower rate overall. 

Invest What You Can

In getting out of the cycle of compounding debt, you should reinforce good habits like regularly investing. Make that interest work FOR you instead of against you.

So invest what you can, when you can.