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Friday, June 22, 2012

Get Rid of Debt first


Get Rid of Debt first

Get Rid of Debt
It is very difficult to save if we are carrying credit card debt or any high interest debt. Let me explain why. Let’s look at one of my colleague’s situation. He loves electronics gadget, entertainment etc. and believes that since he has a job, he should reward himself by buying whatever he wants. 

And, like me and most ambitious individual, he would like to go on nice vacations and buy a house and lot in the future. But how he will achieve this ambitions? He’s spending more than he earned. As a result he owes SAR. 1,000.00 on his credit card. And he doesn’t pay it off in-full. Let’s break it down and see how building up credit card debt makes it impossible to save for future goals.

Imagine that he owe SAR. 1,000.00 in credit card. Every month that he does not pay that debt off in-full, he’s being charged with interest rate of 20% per year by the credit card company for the privilege of the loan they are making to him. That means additional 20% to any balance left on the credit card.

Let’s look at how it plays out. Assuming that he decides not going to add to his debt and he will pay only the minimum payment on his card.

Current debt = SAR 1,000.00
Interest rate paid to credit card company = 20% 
Monthly payment = SAR 30.00
Months to pay = 48 (that’s 4 years)
Total interest paid = SAR 435.00 (on top of the SAR 1000.00)

My co-worker doesn’t like that scenario and decides to tighten his belt and decide to pay SAR 150.00/month to his SAR 1,000.00 debt and not add to it!

Current debt = SAR 1,000.00
Interest rate paid to credit card company= 20% 
Monthly payment = SAR 150.00
Months to pay = 8 
Total interest paid = SAR 50.00

See here’s the different; if he only pays the minimum payment, and don’t even add to the balance, he can end up paying a ton of interest. He pays the minimum per month in the first example and paid an additional SAR 435.00 in interest on top of the original SAR 1000.00.

Would you buy those same electronic gadgets if they cost around 50% more than you’re originally paid for them? I don’t think so.

As you saw in the second example, if my colleague increases his payment to SAR 150.00 each month to pay his debt and didn’t add to the debt. 

In 8 months he get rid of the credit card debt. By increasing his payment, he can markedly speed up his debt repayment.

Let’s reverse the situation and pretend he has zero credit card debt and wants to start saving for his future goals.

Monthly saving payment = SAR 150.00
Interest rate paid by bank = 1.5% (or lower) per year
Balance after 8 months saving = SAR 1,213.00
Total interest received = SAR 6.83

Practical Application

* If he uses the SAR 150.00/month to save, at the current savings rates, he earn about almost SAR 7.00 over 8 months. I know SAR 7.00 isn’t much, but getting SAR 7.00 is still better than paying SAR 50.00 interest.

* Ask yourself would you rather get SAR 7.00 or pay SAR 50.00? 

Clearly, the takeaway is that in order to reach your financial goals, you must eliminate debt first.

Some of you may look at that small interest rate on savings and cringe. Actually, I’m one of those who cringe at the low interest rates on my savings. Don’t worry about the interest rate right now. You see that interest rates go up and down, and we have no control over the interest rates at all. And regardless of how much interest we are receiving on our savings right now, it is better to receive any amount than paying interest on our debt.

As long as you are carrying credit card debt, not matter how much you save, you lose! You can gain more financially by eliminating credit card debt balances than by saving. So pay off your debt first and then saves as you can.



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