The key to debt reduction is principal payments. The more you pay down the principal, the faster the loan will be paid off.

Note I have not mentioned simple interest. Increasing the number of payments you make on the same loan has virtually no impact on your debt, whatever the bi-weekly mortgage zealots out there claim.

You can understand with a simple illustration. You can do duplicate it for yourself if you have a financial calculator. Suppose that you want to borrow \$100,000 and that the interest rate is 6 percent. A normal 30-year mortgage with 12 monthly payments a year will set you back \$599.55 a month. That's \$7,194.60 a year for 30 years.

What would happen if you made 2 payments a month?

Calculate the interest over 24 periods a year instead of 12 and dial in 720 monthly payments over 30 years and your payment will be \$299.64 a month. That's \$7,191.36 a year for 30 years. Increasing the number of payments will save you a whopping \$3.24 a year in interest. Not a lot of magic there. It also wouldn't work very well if you had to mail the payments because the additional postage (12x37cents or \$4.44) would cost more than the interest saved.

But there's still hope.

Suppose you could arrange a money pipeline to your lender so you could make daily payments. Suppose the additional transactions were free. Wouldn't simple interest, with daily principal payments, do magical things?

Sorry.

The same \$100,000 loan would cost \$19.69 a day. That's \$7,188.41 a year. Your saving over the traditional 12 payments a year would be a \$6.19 a year. No one on the planet will get out of debt simply by increasing the number of payments in a year.

What will reduce debt quickly?

Pay more per payment. This will increase the amount of principal paid per period. In the next time period there will be less debt outstanding to accrue interest. As a result, your next payment will require less interest, leaving more money to pay principal. The more you increase the principal payment per period, the faster your debt will disappear.

Therein lies the so-called magic of bi-weekly mortgages. In a bi-weekly mortgage the payment on a traditional monthly payment mortgage is divided in half and you make 26 payments. That means you make the equivalent of 13 monthly payments a year, not 12 payments. So you are paying more principal. Your mortgage will be paid off faster.

How much faster?

You can figure it out using the same financial calculator. Take the monthly payment, divide by 12, and add that amount to each of 12 monthly payments. Do this and you have created the equivalent of a bi-weekly mortgage. You are paying in an amount equal to 13 payments a year.

The \$100,000 mortgage for 30 years at 6 percent, for instance, would have a payment of \$649.51 a month (\$599.55 plus \$49.96). That extra principal payment would pay the loan off in 294.5 payments or 24.5 years. You'd knock 5.5 years off your mortgage and save \$39,268 in interest.

Make the equivalent of 14 mortgage payments a year, adding \$99.92 to each payment, and your 30-year mortgage will be paid off in 251.5 payments, or about 21 years. That's a saving of nearly 9 years and \$65,051 in interest.

It doesn't take much extra money to get impressive results.

The fastest way to get out of debt altogether is to use the power of principal payments to accelerate debt reduction. Both the MS Money and Intuit Quicken software packages have debt reduction calculators that allow you to enter your various debts--- home mortgage, car loans, student loans, credit cards, etc.--- and create different scenarios for getting out of debt. In both calculators the key to rapid debt payoff is to continue a constant total payment even after an obligation is paid off. The result is a quick pyramiding of extra principal payments--- even if you don't increase your original total debt payment. (The Quicken debt reduction calculator is available as an on-line tool at: www.quicken.com/planning/debt)

For people with multiple credit cards, the constant total payment strategy will produce a radically fast reduction in debt. All they have to do is stop adding new debt.

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Thursday, February 10: Figuring the cost of a mortgage