A Different Way of Thinking about Your Debts

If you take out a $200,000 loan for 30 years at 4.5% interest, how much in debt are you?

Some might argue that you’re only $200,000 in debt. However, when you look at the payments you’ve committed yourself to making over the years, you’re actually promising to make payments totaling $364,813.20.

Thus, I’d argue that your actual debt is $364,813.20, even though you actually only received $200,000 in cash out of it.

It’s kind of a scary way to think about it, isn’t it? You get similar scary pictures when you look at the federal budget and examine the pledges we’ve made for future Social Security payments. If we’ve promised to pay it, it’s reasonable to include it as part of our indebtedness.

In fact, I’ve actually moved to calculating my net worth in this way. This number reflects the payments I’m obligated to make in the future. Yes, if I were to liquidate all of my possessions, I could reduce that number, but it’s not realistic to think that I’m going to liquidate my possessions to pay off a mortgage. If you think liquidation is a reasonable assumption, then by all means calculate things with just your debt total.

So, now you’re $364,813.20 in debt. You’re going to have to repay that much money over the next thirty years. You’re going to make 360 payments, one per month, of $1,013.37 each (do the math – if you multiply $1,013.37 by 360, you get $364,813.20).

Here’s the interesting part. Let’s say you add just $1 to just the first payment. This single extra dollar paid drops the entire debt by $2.83. You turned $1 into $2.83 in terms of your net worth. Not only that, you’ll also have your final payment reduced by $1 beyond the $2.83 in interest savings.

Essentially, you invest $1 now and you get it back in 30 years. Along the way it reduces your debt for you by $2.83.

Let’s say you add $100 to just the first payment. You reduce the entire debt by $283.33. You get the $100 back in 30 years and, along the way, it reduces your debt by $283.33.

Let’s say you just add $1 to each payment. You reduce the entire debt you’re going to pay by $399.16. You get your $360 back at the end of the 30 years, plus it reduces your debt by $399.16.

Every time you add a little extra to the payment, the total payment amount you’ve agreed to play goes down. Your obligations are reduced for the future. Not only that, you get the extra money you added back at the end of the debt in the form of a smaller final payment.

For me, the easiest way to keep track of this and of the impact of an extra payment is to use a sophisticated mortgage calculator like this one at Bankrate or, better yet, this Microsoft Excel template. I keep my mortgage data stored in this calculator so that I can see the impact of any extra payments I might make and so that I can see how much I really owe going forward assuming I just make the minimum payments from here on out.

Why think of things this way? For me, there are really three reasons that stand out for looking at debts this way.

One, this method makes it clear how much you’re actually obligated to pay. A $200,000 debt doesn’t mean that you’re obligated to make $200,000 in payments. It means you’re obligated to make quite a lot more.

Two, it’s very clear how much of a positive impact early debt payments can make on your future obligations. The impact is large. Thanks to calculating things in this way, one can really see the big impact extra debt payments make to one’s future obligations.

Three, it lets you see how powerfully debt repayment compares to investing. Without using this method, early debt repayment doesn’t have a powerful impact on your financial bottom line. In fact, it has no impact for the time being – it only shows up very gradually as future payments begin to take advantage of the lowered principal and less of your payments go toward interest. An investment, on the other hand, can quickly begin showing returns that directly show up on your balance sheet.

If you do use this method, though, you can quickly see the long-term impact of an extra debt repayment on your bottom line. Your obligations are immediately lowered by that extra payment, which lets you breathe easier.

To me, knowing my total obligation instead of my total debt feels like a more financially honest approach. It’s the same approach many of us are demanding from our government, so why not apply it to ourselves?

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  1. Trent,
    It is interesting that you view debt this way.
    Of course, the flip side of this (the investing side) is how the financial sales people (Advisors) have been selling for years!
    “If you invest so much per month throught he magic of compound interest, you will have XXX in 30 years”.
    Very few talk about the “magic” of compound interest on debt. I guess it just isn’t sexy material.
    Thanks for sharing your views.

  2. Adam P says:

    So we are to ingore present value and discounting and time value of money concepts because…why? With inflation that $1,000 mortgage payment is going to feel a lot less painful on your wallet than it does today given inflation of 3% a year.

    Prepaying debt when it’s tax deductible and at historical low interest is not always the best idea for your free money. But with the stock markets so volatile, gold in what looks to me like a bubble, real estate looking weak (in the US) perhaps the sure payoff is a good thing afterall.

  3. Des says:

    Oh my. So, do you also use the future value of your investments when calculating your net worth, since you are using the future value of your debt? It isn’t very balanced if you only do this to one side of the equation. I mean, you should do whatever you need to to motivate yourself to pay your debt down, but (yet, yet again) this is not a Net Worth calculation. Net Worth is a snapshot of where you are now, not where you will be in the future.

  4. lurker carl says:

    This exercise calculates the future cost of borrowing money for instant gratification. The actual cost is greater because money not saved never earns interest. It has little to do with your net worth.

  5. valleycat1 says:

    #3 and #4 – +1

    Regarding the mortgage example, you’d also have to project what the actual market value of your house would be at the time you pay it off, since net worth takes into account both sides of the equation.

  6. Steve says:

    Simply put, thinking of debt this way ignores the entire concept of “time value of money”

  7. Johanna says:

    Interesting idea, but I agree with the problems that the others are pointing out. Also, why are you just including debt payments, and not *all* bills you are obligated to pay? I rent my apartment – should I be subtracting my future rent payments from my present net worth? What about things like electric bills, heating bills, grocery bills? They’re harder to predict than your mortgage payment, but they’re bills that you’re just as obligated to pay. (You’re no more likely to stop eating than you are to liquidate all your possessions.)

  8. Riki says:

    Trent seems to prefer self-flagellation as a fuel for his desire to be debt free. If memory serves, he doesn’t even count the current value of his house in his calculations.

    This definition of “net worth” is entirely beyond the spirit of what a true net worth calculation is . . . sure, it seems to work for him but it doesn’t make much sense to me. It’s ridiculous, actually.

  9. Courtney20 says:

    The only reason to do this is if there is a prepayment penalty. Otherwise, you COULD pay off your debt tomorrow if you came into some money (or had it saved up in a higher-bearing vehicle but decided that it was not worth it any longer to carry the debt).

    Again, not a Net Worth calculation. And I always wonder why you feel the need to “trick” yourself into thinking that your net worth is so much more horrible than it actually is.

  10. Brent says:

    Unless you do the same with your fixed return investments too I think this is disingenuous. Net worth is supposed to be the theoretical dollar value you have when you sell all your assets and pay all your debts. By discounting your home’s value and counting your mortgage’s final payments you’ve broken into a realm where that isn’t your real net worth. I think I’ll stick with my Assets-debts=networth calculations myself.

  11. Thanks to others for being more pointed than I about the “Time Value of Money” concept lacking in the post.

  12. Jonathan says:

    While this isn’t a true net worth calculation as others have pointed out, it is a very important factor that people need to consider. When using debt to make a purchase the interest that will be paid needs to be considered as part of the cost of the purchase. Not doing this is why some people will buy an item that is a “good deal” using a high interest loan and end up paying significantly more for the item than it was worth.

  13. MattJ says:

    Trent: Lie to yourself all you like, if it motivates you to pay off debt quicker and you think (hopefully you’ve done a realistic calucation to confirm) that doing so will result in a financially superior outcome.

    My personal calculations confirm for me that paying off my 3.75% mortgage faster than the amortization schedule calls for doesn’t save me a thin dime. In fact, it costs me the opportunity to grow those monies insteada for the next 15 years at a rate that will almost certainly be larger than 3.75%

    I will pass on early mortgage repayment, thanks.

  14. Des says:

    All these Net Worth “hacks” that you do, Trent, are not unlike saying “When I calculate my Gross Income, I like to ignore the amount that will go to taxes, since I have to pay those anyway.” Well, that’s all well and good, but it is not longer your Gross Income.

    If you want to pretend that you owe more than you really do, and you want to pretend that your house doesn’t count as an asset, that is fine. But it is no more representative of your net worth than my gross income is if I ignore the portion that goes to taxes. Heck, while you’re at it, why don’t you just imagine you “owe” a million dollars to your savings account, if that sort of asceticism is what you find motivating.

  15. Karen says:

    The title of the post is ‘A Different Way of Thinking about Your Debts’ not ‘Here’s a better way to calculate net worth’. This post delivers exactly as promised. Thank you for turning things a few degrees to give me a different perspective on my finances. It’s food for thought, and I appreciate it.

  16. aly says:

    As an accountant/CPA I can’t get behind how Trent calcs his net worth. If memory serves me correctly he only includes the outstanding balance of his mortgage in his liabilities without the offsetting value of his house in his assets. Now he’s ignoring the time value of money.

    Quite frankly, this makes no sense to me, but to each his/her own.

  17. aly says:

    I should have added that cash flow and net worth are two very different things.

  18. Kevin says:

    @Tyler: “Very few talk about the ‘magic’ of compound interest on debt.”

    That’s because it almost never happens.

    Note that your credit cards, lines of credit, and mortgage do NOT compound.

    The only debts that compound are negative-amortization debts. That is, debts where the payments you’re making don’t even cover the interest, and the debt is actually growing larger with each payment. Very few debts are structured this way – virtually ALL debts are structured so that each payment reduces the principle, even if only slightly. In those cases, there is no compounding.

  19. Kim says:

    It is not a fair comparison to compare current dollars and future dollars. You are comparing apples and oranges. Assuming 3% inflation, in 24 years, today’s $1.00 will only be worth $.50. You need to understand the concept of the “time value of money”. This is coming up time and time again on your posts. While I understand your intent and your interesting approach, you are doing a disservice to your readers. Please consider taking some financial planning classes.

  20. Holly says:

    Makes me want to sell my house and live in my parents’ basement, LOL!

  21. Telephus44 says:

    I’m with Kim #19 that you seem to totally ignore the effects of inflation, which are incredibly relevant to this calculation.

    I also really think it’s just plain wrong to include this line of thinking into how you calculate your networth. This is a useful way of thinking about debt, but it’s NOT useful to call it something that it isn’t. Net worth may not be a meaningful number for you, so you want to use something else, but it’s really just wrong to come up with something else and just call it net worth.

  22. mary w says:

    I think Trents’s “total cost” concept is valuable for those running a balance on a credit card (e.g., what is this lunch really costing you after interest when you pay for it 2 years from now?). But for all the reasons outlined above, its pretty useless for looking at mortgages.

  23. chuck says:

    i agree with kim. hypothetically, if i owed a bank $10 and they said i could either pay them $10 now or $11 24 years from now, i would elect to pay them later. trent, i guess you would pay them $10 now to save that $1?

  24. mary m says:

    It’s that counting on what your house will be worth in 20 yrs that has gotten the mortgage industry in trouble in our present day. There is no guaranty that your house will grow in value. The reality is that it could decline, or could be completely destroyed leaving you with no value at all and a huge loan. The reality is, if you take out a loan at any interest rate, you will definitely have to pay more than the original loan.

  25. Rich says:

    No, you are obligated to pay the outstanding amount of your mortgage. You may have to pay a prepayment penalty, although in my limited experience I’ve been able to avoid them.

    You are not obligated to pay your mortgage payment for the nominal time period of your mortgage. Every month that you have an outstanding balance, you are required to pay the lesser of your monthly payment or the outstanding balance.

    Trent, I see what you’re getting at–looking at your finances from a cash flow perspective–but it doesn’t change the amount you owe. If you, say, sold the site and paid off the mortgage you’d be paying the hypothetical 200k amount.

    In fact (devil’s advocate here), why not do that? I don’t know what the site pulls in, but I don’t see it as terribly different from the value of a modest house (two to three years earnings I believe is not uncommon for these sites). You’d get rid of that nasty debt you’re talking about!

    I’ll presumptively answer the question. First, the growth potential of the site is arguably more than the current low mortgage rates. Isn’t this, though, much the same as putting money in the stock market in lieu of paying off the mortgage? (Hint: yes, although a big difference is that you get control over what your company does. With the stock market, not so much.) Second, the site is a source of enjoyment. That’s OK.

  26. Courtney20 says:

    “The reality is, if you take out a loan at any interest rate, you will definitely have to pay more than the original loan.”

    Sure, but how much more? Because in Trent’s example, taking out the stated loan is NOT a promise to pay $364,813.20. It’s a promise to pay back the original loan plus accumulated interest. If I take out the $200K loan and a month later my rich great aunt leaves me her entire estate, how much money are they going to ask me for when I go to the bank to pay off my loan? Hint – it’s not $364,813.20!

  27. Laura in Seattle says:

    #18 Kevin
    “Note that your credit cards, lines of credit, and mortgage do NOT compound.

    The only debts that compound are negative-amortization debts. That is, debts where the payments you’re making don’t even cover the interest, and the debt is actually growing larger with each payment.”

    Kevin, what you just described is a subprime mortgage.

    These are the mortgages Countrywide (to choose one example, though they weren’t the only ones offering it) was marketing as “pick-a-payment” – where you could choose to pay one of four monthly payment amounts, including one that did NOT cover the interest accumulating on the loan. (Though of course, they didn’t mention that part.) These loans are one of the reasons the country is dotted with foreclosures right now. So in the case of some mortgages, negative amortization is a very stark reality right now.

  28. Mike C says:

    To me one of the points of the post is to insist that when you buy something using debt you end up paying much more than that object’s price. In the example, you end up paying $364K for something that was worth $200K. Even if you took inflation into account, you still end up paying much more.

    With that said I think that including your future interest payments as a liability in your net worth is just wrong, and misleading. According to Trent calculations adding $1 to your first payment will increase your net worth by $1.83. Now imagine that instead of repaying your debt you decide to invest that $1 at a fictional investment fund that gives you a guaranteed 6% annual return. After the first month the return of the fund is $0.05. From these figures one may think that the reasonable thing to do is to repay the debt, whose return seems to be more than 30 times better. However it is pretty obvious that investing the money at 6% will give you a better return than repaying a debt at 4.5%.

    I think this way of calculating a “net worth” may be a good device to motivate you to pay your debts, but it is not a good way to help you increase your real net worth.

  29. Courtney20 says:

    @ Laura in Seattle – that may be true, but it’s still not relevant to one’s Net Worth (as defined). It just means your net worth is shrinking each month instead of growing. I update my net worth spreadsheet monthly with the balances of our debts, and there’s no reason a person with a negative amortization mortgage shouldn’t do the same; the numbers are just going to move in different directions.

    And if you were going to apply Trent’s principle to a negative amortization loan, shouldn’t you technically have infinite debt? :-)

    (I know that N.A. loans have balloon payments due. I’m just trying to point out the silliness of extrapolating payments to what you owe today).

  30. Mike C says:

    Actually I think that the issue of debt repayment vs investing could be visited in more detailed post. Trent, you talk about that topic frequently in the Reader Mailbag, but I don’t think that you have had a post like that in a while.

    For instance, let’s assume that you have just bought a house for $250,000, with $50,000 down, and a 30 year mortgage for $200,000 at 4.5%. In addition to your monthly payment you want to put some extra money to accelerate repaying your house. You can put that extra money into early repayments, or you can invest it in some fund; then when that fund has enough money you liquidate it and use it to pay off the balance of your mortgage.

    What are the pros and cons of each alternative? There are plenty of issues to take into account: taxes, cash flow, risk, market returns, evoluation of home values,… Personally I think that investing the money is better than directly repaying the debt, because of cash flow, but other people may have different reasons…

  31. Angie says:

    “Let’s say you add just $1 to just the first payment. This single extra dollar paid drops the entire debt by $2.83. You turned $1 into $2.83 in terms of your net worth. Not only that, you’ll also have your final payment reduced by $1 beyond the $2.83 in interest savings.

    “Essentially, you invest $1 now and you get it back in 30 years.”

    Having the final payment reduced by $1 is not the same as getting $1 back in 30 years. You wouldn’t really be getting the $1 *back*, you’re just not having to pay it later (because you paid it earlier), right?

    Am I missing something? I’m not quite the financial genius some of you are :)

  32. travis says:

    I disagree that you should pay $1 or $100 extra per month or once on your mortgage. A $1 today will be worth less in 30 yrs. If you pocketed $1 back in 1980 it would be worth about $2.32 (depending on your source) in 2010 (latest yr for data). A better idea would be to take that $1 or extra $100/month and put it in your rainy day fund or at least in a money market account that presently earns an abysmal 1% . If you put that $1 in savings every month – after 30yrs you’d have $360. While not amazing, it was completely liquid. And interest bearing – @1% almost $60 over 30yrs. Yes, its pretty sad – however rates will improve, you will have unexpected costs – and of course if you have to default on your loan you never get that money back. To make it sound more interesting – with $100/monthly put into a 1% account after 30yrs – you would have $42k! Now that sounds like some good money to celebrate with!

    Its good to be mindful of debt – but long term debt is a completely different beast than credit cards – if you have $200k on credit – I’d recommend paying that off immediately.

  33. todo es bien says:

    Well, win some lose some Trent. I would say there is NEVER an advantage in creating a distorted image of your financial position unless you are such a dope that distortion is the only thing that could get you to improve your behaviors.
    In this example, you create a model that is so far at odds with reality that it could easily cause you to take foolish actions. The best image is the most accurate image, and that means you have to model in the time value of money, inflation, opportunity cost, etc. Granted to some degree you have to make assumptions. That is the nature of all forward thinking. Keep those columns coming though.

  34. BJD says:

    I agree with #30 Mike C — that would be interesting post to see the options and the thresholds for when one option is better then the other

    and #31 Angie – I agree that Trent’s wording was misleading “Essentially, you invest $1 now and you get it back in 30 years.”…..no, not really

  35. Julia says:

    I think some people here are missing the point.
    If you buy a house for $200,000 with a 30 year loan at 4.5% interest, then you actually bought that house for $364,813.20. That’s the part that matters. All that stuff about net worth and getting money back kinda muddy’s the waters of a very good point.

    Imagine negotiating for this house. The appraiser values it at $200k. You offer $200k. The bank counter-offers with $365k. You accept. That is more or less what you do when you finance something. The difference is that each time you make a larger-than-required payment, you’ve just renegotiated. If that first payment is $1 over the minimum, you’ve reduced the final price by $2.83

  36. Courtney20 says:

    But you didn’t buy the house for $364,813.20 and THAT’s the point. You bought the house and the option to pay for the house over a period of up to 30 years. If, for example, you pay it off in 10 years instead (by paying an extra $1060 per month) then you’ve only paid $248,713.39 for the house. The bank doesn’t have any right to ask for the additional $116K.

  37. Genny says:

    I agree with commenter #35-Trent’s point is so important that lenders are obligated to put the total principal and interest paid (the $364,813.20) on the Truth In Lending disclosure that buyers must sign. I worked years ago in mortgage lending and most buyers signed the disclosure without really reading it. Some buyers did question that figure and were blown away by what they were really signing up for.

  38. Jonathan says:

    Let’s look at an example of where Trent’s idea is valid and very helpful. Lets say that I bought a house for $240k and pay $40k down, financing the remaining $200k @5%. I keep the house for 5 years at which time I sell it for $276k. Did I make $36k on the house? Or did I actually lose nearly $15k? I’ve seen a lot of people in a similar situation where they buy a starter home, keep it for a few years, then sell it for a few thousand more than the original purchase price and think they made a profit. Trent is simply suggesting that its a good idea to consider the full cost up front. So what if you pay it off earlier? You just end up paying less than expected. That’s actually what Trent is suggesting. The fact that his idea of using this to calculate net worth might be a bad idea doesn’t mean the entire point is invalid.

  39. Holly says:

    @38:

    You didn’t actually lose money over those years that you were paying the mortgage; you were paying ‘rent’ to the bank.

    Unless you live under someone else’s roof, out by the rr tracks, or in a shelter, we all get to pay for our living quarters. Add up the cost of a year’s rent and it’s probably somewhat equal to your mortgage payment + taxes.

  40. PK says:

    I just wanted to point out a part of the article that I think is missing.

    After you’ve paid off the loan in an accelerated fashion, you could continue paying out the rest of the schedule to yourself (pick a savings vehicle). After the schedule is complete, you won’t be too far off of the value of investing the acceleration funds during the entire schedule.

    Personally, I think this is a very interesting concept. I’ve integrated it into my Net Worth spreadsheet, but I’ve also included it in such a way that I can turn it on and off to look at in both perspectives.

    For the people that have made the choice to pay off the mortgage, a la Dave Ramsey, I think that this would be the most accurate way to report how much was ‘paid off’, “I paid off a 200k loan, that was going to cost me almost 365k if I hadn’t taken action.”

  41. Pam McCormick says:

    I think this is a very interesting and great topic for the times and what is going on in the world(not just housing.I live in upstate NY bought a small(1300sq ft) cape cod 1 acre of land in 1981.It was what I could afford at the time,put 20% down and took a balloon mort for 5 yrs at 13% because I thought rates would drop and I could refinance.That was very risky but it paid off and in 5 yrs I refinanced and continued every time the rate dropped by 2% and did not require closing costs.We paid off the house in 25yrs instead of 30yrs using yearly tax return of approx 1K.I do not know how much we really paid for the house and would probably be sick to see the real amount.I was young and very uneducated about finances but I did know to only buy what I could afford-and keep it,take good care of it,pay it off as soon as possible to save in the long run.We are starting our 30th year in the house it’s not perfect but it’s mine and going into retirement eventually with no debt we will survive and enjoy.It might not be for everyone but for piece of mind it’s terrific.

  42. AnnJo says:

    Back when I had a mortgage, I thought of prepayments on it as more or less equivalent to investing in bonds, which allowed me to invest my other funds more heavily in equities. There was some liquidity risk, but that could be countered by maintaining a healthy (mostly unused) line of credit.

    Regardless of whether it’s the optimum investment vehicle, though, there are few things so financially liberating as being mortgage-free.

  43. Georgia says:

    I agree with Trent & Genny. You are paying much more. I even had a bank clerk question me on this when I was an S&L Branch Manager. She called for a payment on a certain amount for 30 years. The interest rate at that time was 10%. (It got even higher in the 80′s.) I gave her the figure & in a short time she called me back to recheck my figure. She said it couldn’t be possible. She would be paying 3 x’s the amount for her home purchase. I said, correct. Why, as a bank worker, didn’t she know that?

    I always advised my customers to just even out their payments. If the payment was $277.50, just round it to $300 and make that payment regularly. It would cut somewhere between 5 & 10 years off the end of the loan.

    And yes, the full amount to be repaid under the terms of the loan, must be disclosed to you at the loan closing.

    And all these comments about using the extra to invest instead of prepaying is a bunch of nonsense. Some few people may do it, but the vast majority of people just spend it on something else. And, in the last 3-5 years, a paid off mortgage gave you much more than the investments you made. Peace of mind, no more payment, etc. And I think the loss of so many homes proves my point.

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