The image that scared me about debt

Posted on April 11, 2012

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I wanted to share a picture that changed my mind about how money works.  I was turned off of being in long-term debt from when I was in my teens.  Maybe it was in math class where we had a very quick unit on interest.  Well, I remember seeing an image in a textbook very much like this one (and it shocked the heck out of me):

Compound Interest.  I can’t begin to tell you how nuts this is.  Basically, this picture shows that if you borrow $200,000 from a bank, say, to start a business or to buy a house, agreeing on a 30-year mortgage and it charges you 6.5% per year (not written on the graph), you end up paying all that PURPLE section in interest!  You can’t accurately tell by just looking at this ying-yangish graph, but at 6.5%, this causes your interest payments to be MORE than the loan itself.  Overall, you will pay about $450,000 over 30 years, with only 200,000 of that going toward the house / business and 250,000 of that  in interest (=the fee to borrow the money)!  That’s a ker-azy fee.  (Think of what the picture looks like for interest rates of 12% or 18%—those are regular credit card fees!)

In 2012, in Canada, the interest rates are LOWER–at around 3% for people with good credit.  So, interest is not as much, but it does end up being about $100,000 over 30 years (if the loan was $200k).  This is not even thinking about property tax or any insurance that you also would pay in addition to this, if you’re thinking of buying a house.  There are many mortgage calculators online that can help you figure out your situation with info graphics: http://www.mortgagecalculator.org/

Or why not get up to speed on all the basic math required for personal finance: Wise Bread has a great entry for this.

Implications?

We have all heard the long-held “wisdom” that buying is smarter than renting.  But, using this case, if you realize that you would have to sell your house or business in 30 years for at least $450,000 (= all the money you put into it), including inflation rates over the years etc. to just break even (meaning zero gain)…you should compare that to the money that you would otherwise have (by NOT paying interest, property tax etc. because you are renting at a cheaper rate) and see that had the savings been invested, if it would be worth MORE than $250,000 over 30 years by the interest it earns for you.  (Ack, that was ONE sentence!)

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