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Wednesday, September 18, 2019

On first hearing, this statement sounds true:

“When you make extra payments on a credit card balance with 16 percent interest, it’s like earning

16 percent.”

This simple analogy encourages consumers to pay off high-interest debt as fast as possible, even if it means reduced saving. But is it really a good idea?

The truth requires more than a simple analogy.

Start at 175 Months…

Let’s look at the terms of a typical credit-card. Assume the following:

• An $8,000 credit card balance.

• Annual interest rate of 16%, compounded monthly.

Note: Many credit cards compound interest daily instead of monthly. As of October 2018, per Credit Card Monitor, the average credit card interest rate was 16.71%.

• Minimum monthly payments equal to 3% of the outstanding balance, or $25.

Assuming no new purchases, here are the payments for the first 5 months:

MINIMUM MONTHLY PAYMENT (@16%)

Month

Beginning Balance

Monthly Payment

Interest Charge

Remaining Balance

1

$8,000.00

$240.00

$103.47

$7,863.47

2

$7,863.47

$235.90

$101.70

$7,729.26

3

$7,729.26

$231.88

$99.97

$7,597.35

4

$7,597.35

$227.92

$98.26

$7,467.69

5

$7,467.69

$224.03

$96.58

$7,340.24

Because minimum payments decrease as the balance diminishes, the repayment period runs long. The final payment doesn’t come until the 175th month (14 years 7 months!). This hardly qualifies as “speedy” debt reduction.

Take It Down to 44 Months

Instead of paying the minimum, keep paying $240 every month. This reduces the payoff period to 44 months, which is much better than 175 months, but it isn’t the “accelerated” debt reduction program many experts recommend.

Accelerate to 18 Months…

To really speed up the process, make extra principal payments, perhaps using dollars previously allocated to saving or investment. Let’s add $260, for a $500/mo. payment.

Month

Beginning Balance

Monthly Payment

Interest Charge

Remaining Balance

1

$8,000.00

$500.00

$100.00

$7,600.00

2

$7,600.00

$500.00

$94.67

$7,194.67

3

$7,194.67

$500.00

$89.26

$6,783.93

4

$6,783.93

$500.00

$83.79

$6,367.71

5

$6,367.71

$500.00

$78.24

$5,945.95

6

$5,945.95

$500.00

$72.61

$5,518.56

7

$5,518.56

$500.00

$66.91

$5,085.48

8

$5,085.48

$500.00

$61.14

$4,646.62

9

$4,646.62

$500.00

$55.29

$4,201.91

10

$4,201.91

$500.00

$49.36

$3,751.26

11

$3,751.26

$500.00

$43.35

$3,294.61

12

$3,294.61

$500.00

$37.26

$2,831.88

13

$2,831.88

$500.00

$31.09

$2,362.97

14

$2,362.97

$500.00

$24.84

$1,887.81

15

$1,887.81

$500.00

$18.50

$1,406.31

16

$1,406.31

$500.00

$12.08

$918.40

17

$918.40

$500.00

$5.58

$423.97

18

$423.97

$423.97

$0.00

$0.00

$500/mo. PAYMENT (@16% interest)

FACT: Extra payments dramatically reduce the time to payoff. In this example, making extra payments changed the payoff period to 18 months, from 175.

FACT: Extra payments significantly decrease interest costs. In the minimum-payment scenario, the total payments are $13,687.29, with $5,687.29 in interest. In contrast, the total payments for the $500/mo. plan are just $8,923.97, an interest savings of $4,763.32.

Accelerated paydowns appear to be as good as advertised.

Let’s Try 19 Months… Because It’s better.

Rather than sending an extra $260 to the credit-card company, you could deposit that same amount into a savings account, while continuing to make $240 monthly payments. When the savings account equals the remaining balance, you make one lump-sum payment to clear the debt.

Interest rates for savings accounts are very low. Some might argue you “lose money” by not applying the additional savings directly to the card balance each month. Consequently, saving in an outside account will take longer to pay off. But how much longer?

$260/mo. SAVING (@ 1%)

Plus $240/mo. PAYMENT

Month

Beginning Balance

Monthly Payment

Interest Charge

Remaining Balance

1

$260.00

$0.22

$260.22

$7,863.47

2

$260.00

$0.43

$520.65

$7,725.11

3

$260.00

$0.65

$781.30

$7,584.91

4

$260.00

$0.87

$1,042.17

$7,442.85

5

$260.00

$1.09

$1,303.25

$7,298.88

6

$260.00

$1.30

$1,564.56

$7,153.00

7

$260.00

$1.52

$1,826.08

$7,005.18

8

$260.00

$1.74

$2,087.82

$6,855.38

9

$260.00

$1.96

$2,349.77

$6,703.58

10

$260.00

$2.17

$2,611.95

$6,549.76

11

$260.00

$2.39

$2,874.34

$6,393.90

12

$260.00

$2.61

$3,136.95

$6,235.95

13

$260.00

$2.83

$3,399.78

$6,075.89

14

$260.00

$3.05

$3,662.83

$5,913.70

15

$260.00

$3.27

$3,926.10

$5,749.35

16

$260.00

$3.49

$4,189.59

$5,582.81

17

$260.00

$3.71

$4,453.30

$5,414.05

18

$260.00

$3.93

$4,717.23

$5,243.04

19

$260.00

$4.15

$4,981.37

$5,069.74

At the end of 19 months, the savings account has $4,981.37. If you take this balance and add a payment of $88.37 at the start of the 20th month, the credit card is paid off in less than 2 years.

Wait…only one month difference?

How is that possible?

Being charged 16% interest while earning 1% should be a lopsided financial equation. But in this example, other variables make it less relevant.

The $240 monthly payments have already shortened the amortization schedule considerably; in shorter payback periods, interest charges don’t have as much time to compound. Over 18 months, the additional interest incurred by saving at 1 percent, instead of making extra payments to the credit card is just $300.

If the payments were smaller, the amortization period was longer, or the additional principal payments were proportionately lower in comparison to the basic monthly payment, the spread between the time it takes to achieve full pay off could be much greater.

FACT: Every debt-reduction scenario is unique and deserves to be evaluated individually.

Control Your Surplus

This financial exercise highlights several important thoughts.

Paying down debt is not the same as saving. Some financial commentators confuse the two ideas, or view them as interchangeable. They are not. When all your surplus is put toward debt deduction, you have no capital reserves to take advantage of opportunities or meet unexpected challenges. If you need more money, you end up borrowing again, where the decision-making power lies with the lender, not you. No matter what the interest rates are, paying off debt is not “saving.”

Debt is a control issue. When you owe money, a creditor exercises a measure of control over your finances until the loan is satisfied. Paying a debt faster (by making extra principal payments) without paying the balance in full does not remove this claim; you still must make next month’s payment.

In fact, you could argue that additional payments on debt obligations actually give more immediate control to the lender, because extra principal payments put more money in a lender’s hands while also reducing the amount they might lose if you defaulted.

Department store magnate Marshall Field succinctly explained the benefits of keeping “extra” money under your control.

“A man with a surplus can control circumstances, but a man without a surplus is controlled by them, and often has no opportunity to exercise judgment.”

Getting rid of debt as quickly as possible is a sound strategy. But you also need to evaluate how much control you sacrifice by repaying more than is required. Saving to make a lump-sum payment may often be a better format for accelerated debt reduction.

2018-69502 Exp. 11/20

This article was prepared by an independent third party. Material discussed is meant for general informational purposes only and is not to be construed as tax, legal, or investment advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon only when coordinated with individual professional advice.

Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS), 355 Lexington Avenue, 9 Fl., New York, NY 10017, 212-541-8800. Securities products and advisory services offered through PAS, member FINRA, SIPC. This firm is an agency of The Guardian Life Insurance Company of America® (Guardian), New York, NY. PAS is an indirect, wholly owned subsidiary of Guardian. Wealth Advisory Group LLC is not an affiliate or subsidiary of PAS or Guardian. Wealth Advisory Group LLC is not registered in any state or with the U.S. Securities and Exchange Commission as a Registered Investment Advisor. Neither Guardian, PAS, Wealth Advisory Group, their affiliates/subsidiaries, nor their representatives render tax or legal advice. Please consult your own independent CPA/accountant/tax adviser and/or your attorney for advice concerning your particular circumstances.

2019-73298 Exp. 1/21

Submitted by Elozor Preil