Sent to you by Chris Hunter via Google Reader:
If you take out a $200,000 loan for 30 years at 4.5% interest, how much in debt are you?
Some might argue that you're only $200,000 in debt. However, when you look at the payments you've committed yourself to making over the years, you're actually promising to make payments totaling $364,813.20.
Thus, I'd argue that your actual debt is $364,813.20, even though you actually only received $200,000 in cash out of it.
It's kind of a scary way to think about it, isn't it? You get similar scary pictures when you look at the federal budget and examine the pledges we've made for future Social Security payments. If we've promised to pay it, it's reasonable to include it as part of our indebtedness.
In fact, I've actually moved to calculating my net worth in this way. This number reflects the payments I'm obligated to make in the future. Yes, if I were to liquidate all of my possessions, I could reduce that number, but it's not realistic to think that I'm going to liquidate my possessions to pay off a mortgage. If you think liquidation is a reasonable assumption, then by all means calculate things with just your debt total.
So, now you're $364,813.20 in debt. You're going to have to repay that much money over the next thirty years. You're going to make 360 payments, one per month, of $1,013.37 each (do the math – if you multiply $1,013.37 by 360, you get $364,813.20).
Here's the interesting part. Let's say you add just $1 to just the first payment. This single extra dollar paid drops the entire debt by $2.83. You turned $1 into $2.83 in terms of your net worth. Not only that, you'll also have your final payment reduced by $1 beyond the $2.83 in interest savings.
Essentially, you invest $1 now and you get it back in 30 years. Along the way it reduces your debt for you by $2.83.
Let's say you add $100 to just the first payment. You reduce the entire debt by $283.33. You get the $100 back in 30 years and, along the way, it reduces your debt by $283.33.
Let's say you just add $1 to each payment. You reduce the entire debt you're going to pay by $399.16. You get your $360 back at the end of the 30 years, plus it reduces your debt by $399.16.
Every time you add a little extra to the payment, the total payment amount you've agreed to play goes down. Your obligations are reduced for the future. Not only that, you get the extra money you added back at the end of the debt in the form of a smaller final payment.
For me, the easiest way to keep track of this and of the impact of an extra payment is to use a sophisticated mortgage calculator like this one at Bankrate or, better yet, this Microsoft Excel template. I keep my mortgage data stored in this calculator so that I can see the impact of any extra payments I might make and so that I can see how much I really owe going forward assuming I just make the minimum payments from here on out.
Why think of things this way? For me, there are really three reasons that stand out for looking at debts this way.
One, this method makes it clear how much you're actually obligated to pay. A $200,000 debt doesn't mean that you're obligated to make $200,000 in payments. It means you're obligated to make quite a lot more.
Two, it's very clear how much of a positive impact early debt payments can make on your future obligations. The impact is large. Thanks to calculating things in this way, one can really see the big impact extra debt payments make to one's future obligations.
Three, it lets you see how powerfully debt repayment compares to investing. Without using this method, early debt repayment doesn't have a powerful impact on your financial bottom line. In fact, it has no impact for the time being – it only shows up very gradually as future payments begin to take advantage of the lowered principal and less of your payments go toward interest. An investment, on the other hand, can quickly begin showing returns that directly show up on your balance sheet.
If you do use this method, though, you can quickly see the long-term impact of an extra debt repayment on your bottom line. Your obligations are immediately lowered by that extra payment, which lets you breathe easier.
To me, knowing my total obligation instead of my total debt feels like a more financially honest approach. It's the same approach many of us are demanding from our government, so why not apply it to ourselves?