AoM 21st: Pay down your debts before you invest!

Last week I explored the term Annual Percentage Rate (APR) in anticipation of tackling some age old advice. Let’s dive right in!

The Advice: Pay down your debts before you invest!

Why do we urge people to get rid of their debt prior to investing? Well, most debt is composed of two things: a “principal” amount which represent the actual amount you owe, and an “annual percentage rate” which determines how much you will be charged for having that outstanding principal.

At some point (most likely) you determined a payment schedule that would result in the debt getting paid off over the course of X years, which is called an amortization schedule. Still with me?

The reason you are told to pay off your debts first is because when you pay off a debt, you are basically ‘paying yourself’ back the APR of that loan. So if you have an amount in loans at 8% and an equal amount of savings you can guarantee an 8% return on investment just by paying off your loan!

Most people (especially those new to investing) can’t guarantee a return on investment at all. Just to break even you’ll need to generate more than your APR in returns! Otherwise you’ll essentially lose all of your returns to that extra money paid to your loan in the time that it takes to accumulate your new wealth.

The Box

Welcome Boxers, to amortization hell.

You have a $30,000 loans at 8% APR for this totally tricked out rubber ducky for bathtime. This ducky has it all, bigass rims, a gold-plated beak, seatwarmers so it makes your bathwater nice and hot before you get in, and remote-start to boot! Your rubber ducky has brought you hours of happiness but you had a big financial windfall recently and all your relatives are badgering you to invest it. According to your amortization schedule, ducky will take 5 years to pay off with your monthly contribution of $608.29 to the Lake Account.

You find $30,000 in a paper bag and ask a total of no one whether or not it’s theirs before absconding with your newfound riches. You tell everyone you got it for walking a dog and your family is made up of the best damn dog-walkers in the United States so no one goes sniffing around your little windfall.

At the same time, uncle Burt says he knows the secret to investing and lets you in on the ground floor of this penny stock for a medical technology company. He thinks you could double, maybe even triple your cash in a few years.

Well, uncle Burt was always an asshole so you invest in an index fund instead. Lucky you! Uncle Burt’s penny stock becomes worthless and you come out ahead with a 10.23%* return on investment in 5 years. Good job! That comes out to less than 2% per year! Oh, wait…

You paid out 8% per year on that loan! So you make $3,069 on investments and pay out $6,497** to your loan in interest. You’ve still paid $30,000 over 5 years to pay off that loan. Oops!

_{* Based on, erm, Vanguard’s highest-performing index fund (existing for at least 5 years… Long-Term Bond Index! https://personal.vanguard.com/us/funds/vanguard/index?loc=&View=PP&Sc=0 (as of December 11, 2012)}

_{** Based on this amortization calculator, http://www.amortization-calc.com/#loan-30000-5-8-12-2012-2}

So, some people think they can beat the market and some may. Unfortunately there’s a lot more at work in the market then simple timing things and doing your research. Just ask anyone who was invested into Enron or Freddie Mac. Just be careful out there, and if you want some guaranteed ROI, start busting down those loans!

Term: Annual Percentage Rate (APR)

The Term: Annual Percentage Rate (APR)

APR is something everyone runs into pretty early into adulthood but few really think about. It’s applied to loans, credit cards, and savings accounts, and is the source of a lot of confusion and aggravation. To add to the confusion some people are given ‘variable APRs’ that can change every day. Jees! We'll handle variable APRs in another post.

The Annual Percentage Rate is the total rate that your debt will generate additional debt in a given year.

I’m going to use a term called ‘the box’ when we go into territory where only the things I say matter. In the real world there will be other considerations but ‘the box’ allows me to set the rules so that other things don’t interfere and make the situation more complicated.

The Box

So lets take a quick vacation to ‘the box’ and say you got a credit card with 15% fixed APR. That 15% APR works out to 1.25% per month that you ‘carry a debt’, meaning you don’t pay it off in full.

One day you’re cruising through the mall and notice some cool stuff you can’t live without, an Apple laptop ($1500), an iPad ($600), a new XBox 360 ($250), some assorted jewelry ($600), a new table ($1000), and a shopping spree at Express ($1050).

The important part is you’ve wracked up $5000 in purchases on that 15% card all in one day and now you decide that you’ve had enough and go home to enjoy all this cool stuff you purchased.

A month goes by and you don’t pay by your due date and ‘carry’ the debt over. Your credit card company says "Hey, remember that money we loaned you? You’re paying for that privilege. We’re charging you an additional $62.50 (1.25%) of your $5000 loan and you now owe us $5062.50."

Holy crap! You just got nailed for $60 for nothing. That’s like, 2 nice meals. 3 bottles of decent wine. That’s 30 bottles of water. That’s a new shirt! Why did you carry that debt? Ah hell you’ll deal with it next month...

Another month goes by. The credit card company comes back again. "Hey man, you still didn’t pay. Here’s another $63.28. You owe us $5125.78".

What? Why did it go up? Because you didn’t pay off that original amount, now they assess your additional debt on top of what you actually charged.

Imagine if you had three times that amount, $15,000 weighing you down. Now your monthly interest charge is $187.50. You’re being charged almost $200 dollars a month just for the privilege of using someone else’s money in the past. Just to break even you have to pay $187.50, even more to start paying it down.

So as you can imagine, those APRs can be killer. If you are younger or have a bad credit score you could be saddled with APRs of over 24% (2% a month)!

How to determine the amount you’ll be charged:

(Note: Example APR as decimal: 15% would become .15)

Cost of Carrying a Balance = (APR as decimal / 12) * Balance

Why APR?

Why indeed! The Federal Government wants you to be able to understand financial matters in a big overarching way. This levels the playing field when it comes to percentage rates, making many kinds of financial decisions pulled back into the fold of APR. Your savings account figures are generally in APR (though it's called your interest rate), so are credit card rates, personal loan rates, mortgages, car loans, etc.

The idea is once you understand APR, you understand the way most financial engines operate. Once that's handled, you can start making informed decisions about your financial future. Unfortunately, most people learn this lesson a little late, after they've already signed up for bad loans with high APRs.

Here's hoping you avoid learning from the school of hard knocks!

Introduction

Welcome to the Art of Money in the 21st Century blog!

My Mission

There’s a lot of information out there about how to manage your money and what the right thing to do with it is, but there’s a certain kind of person out there who isn’t quite represented. I’m talking about the kind of person who doesn’t ‘get’ something until they understand the fundamentals behind it.

I call it ‘telling resistant’. If I’m being told something, I’ll resist learning about it. As you can imagine, this meant I had a lot of problems in a lot of classes in school. Instead of learning something ‘because it is that way’ I had to understand the logic behind it, the real reason why something works. The farther I got into trigonometry, for instance, the more I had to understand why pi = 3.14. But this is a financial blog, not a mathematics blog!.

So I’ll be doing my best here to explain exactly why any given financial terms/advice exists, and what the actual skinny is in terms anyone could understand. I’ll also pepper in some advice and information on different topics for those looking to be frugal or make the system work for you.

My Experience

Now, I'm going to come completely clean here. I'm not part of the financial system. I work for an insurance company, as of 2012 I'm 25, and my experience here is reflected just by an obsessive observance of 'the system'. I enjoy looking over this stuff and learning about it, so I thought I'd just reinvest in people and try to share what knowledge I have gleaned on the terms I understand it.

I'm looking for people to call me out if I misrepresent something and call for clarification when I become complex or obtuse. It's all about understanding here, and if I'm not clear in my writing then I need someone to comment. So don't be afraid to call me out!