For many, having debt such as a mortgage payment and car payment is unavoidable. Ideally we would pay cash for everything but the reality for most is that is not possible for one reason or another. There are, however, some simple things that we can do to make the process go smoother and save money in the long run.
I think we all know that when you buy something on credit you are paying interest so when you finish making your payments your $10,000 car really costs about $20,000. You can see for yourself how much you are paying for something by multiplying your monthly payments by the number of months in the term of the loan. The interest accrues (or adds up) daily so the sooner that we make payments the better.
When you sign a loan a lending company gives you terms. In the terms they will specify how much interest they will charge and how much you need to pay every month to stay current. Most people assume that they have to make one payment every month but you can actually make as many payments as you want a month. You may not be able to make the full payment several times a month but nothing is preventing you from multiple payments that add up to your monthly payment.
It works like this: Let’s say you’re paid biweekly like most people. If your monthly payment is $250 you would send them $125 each paycheck. You’re still paying $250 every month but because you are dividing up the payment you are saving interest. Also, because there will be a couple of months a year where you will receive three paychecks in a month, you are actually making one or two additional payments a year.
The results can be dramatic and you wind up reducing the term of the loan by many months (or years) and you save thousands in interest. Let’s look at an example:
In this example, we have a 100,000 mortgage and if we just made monthly payments we pay $182,404 for our house. However, if we pay the exact same amount but split in half and paid biweekly, we only pay $168,385 or a savings of $14,018. As a bonus, our loan is paid off 53 months (over 4 years) quicker and it costs us nothing more to pay this way.
This can be applied to any type of debt that has a regular payment and you’ll wind up saving money in the long run. If you have extra money to apply to your loan, it will have a greater impact than if you just applied that amount on a monthly basis.
The other thing that I like about this payment method is that it
lessens the impact of larger payments by taking a smaller portion of your
paycheck to meet
the bill. This means that you can pay
more bills or have more money available to you each pay period.
Credit cards & credit score
Another type of monthly bill is your credit card. Credit cards should never be used as a “savings” account or other type an extension of your real monthly income. They should be used however because they improve your credit score and having a better credit score means lower interest rates when you do need to borrow. As we’ve talked about, we know how to shorten the term of our loans and reduce the amount of interest that we pay but the lower the interest rate, the less we will have to pay and our goal is to reduce what we have to pay so we have more money for other things.
- Use all your cards
- Leave a balance under 10% of your total available credit on one card
- Make on-time payments
I think we all know that making payments on-time is good for our credit but that alone will not give you a high credit score. Many people think that they have excellent credit because they have tons of credit cards or that they pay their bill off ever month but they may be surprised to know that their score can be better. Credit scores rise when you use your credit and pay it on-time. If you pay your bill off each month you have no utilization and if you only use one card, you only show one on-time payment each month.
The most widely used scoring system is called your FICO score. You can get an approximation of your score from services like Credit Karma (CreditKarma.com) but while close, those are sometimes called FAKO scores. No one really knows what the real formula is for your FICO score but we can guess based on real world experience.
We know that we get points for utilization (how much we use our credit) and we know that the optimal range is less than 30% of your total available credit. This isn’t each card, but your overall available credit. For example, if you have four credit cards, each with a $5000 credit limit, you have $20,000 in credit available to you. Ideally, you’ll get the most points for having $2000 or 10% utilization on your cards.
You also get points for having on-time payments so if you don’t use all your cards, you only get points for making one on-time payment. So, if you use all four of your cards and make on-time payments on all four cards, you will get four times the points as if you just made one.
It’s also good practice to rotate through your credit cards as to which one you leave a balance on. So use your cards and pick a different card each month to leave a balance of less than 10% of your total available credit. This will give you an ideal credit utilization rate and your score will rise towards 800!
The best ratio of cards that I have read is four major credit cards and one store card (like Target or Sears). So if you don’t have that mix of cards, it’s a good idea to apply, even if you don’t need them because it can be good for your credit score in the long run.