QuestForAMillion.net

We’ve all read it and heard it a hundred times: “It’s better to earn interest than pay interest.” Why? For some the answer may be obvious, but I thought I would illustrate a real-life example for everyone’s benefit, my own included.

We recently paid off about a $14,700.00 balance on a car loan. Doing so saved us about $2100 in interest. There were still 50 monthly payments to make on the loan which had an interest rate of 6.5%.

For the following calculations, we’ll conveniently ignore taxes for simplification purposes. Bear in mind though, taxes will reduce interest earned, but have no effect on interest not paid.

Had we been able to keep that $14,700.00 in our savings account earning 5.05%, the account would be worth about $18,134.00 in 50 months. An interest gain of $3434.00.

If we paid off the loan according to the terms, keeping the money in savings, we come out $1334.00 ahead ($3434 interest earned - $2100 interest paid).

By paying off the loan, we can put the $300/month loan payment into savings. This makes the savings account worth $16,656 in 50 months, which is interest earnings of about $1656.00. This puts us $3756 ahead ($1656 interest earned + $2100 interest saved).

So it seems like we made the best financial decision, pay off the loan and put the money saved on the loan payment each month in savings.

But, what if we never had the loan in the first place? Let’s ignore the last 10 months of car payments and take it from today. Now we have $14,700 in savings and we can put $300/month into the account. We’re still earning 5.05% on the account. In 50 months the account is worth $34,790.00! This equates to an interest gain of $5090.00, far ahead of the interest gain on the starting account balance alone and much more than we’d earn just by putting $300/month into the account. No wonder Einstein said compound interest is the most powerful force in the universe!

By taking out the loan in the first place we severely handicapped the earning ability of our money. Not only did we diminish earning ability but we also paid interest, a fatal combination. It’s running numbers like these that make me want to avoid debt more than ever. Note that we actually are putting the money that used to go to the car payment into savings. We’ll build up our account, earning interest along the way until we can pay off the next car loan.