Debt sucks! It’s like a dull, chronic pain that just lingers around. An irritating reminder that your cash flow is not as positive as it could be. However, there’s a simple hack that can accelerate your debt repayment plan and get your to debt freedom sooner.
Most Canadians Have A Significant Amount of Debt
Often, large amounts of debt are accompanied by feelings of shame. Having spent time in the finance industry, I found many people were often reluctant to speak about the topic because they were embarrassed by the level of debt they had accumulated. They should not feel alone, or ashamed.
The average Canadian has over $28,155 in debt, excluding mortgages. That is a lot of consumer debt. Even at payments of $430 per month, it would take you 7 years to pay it off. That’s nearly half a grand, every month, for nearly a decade, just to be free of the stronghold the banks have on the “Average Canadian.”
Wouldn’t it be nice to spend that money on something of value to you?
Perhaps you want to travel more. Or maybe have a few more fancy date nights each year. How about plugging more money into your emergency and retirement funds? Or increasing the savings for your children’s education? Start a new business? Buy a new home? Whatever financial goals you may have, debt is robbing you of opportunities for as long as you have it.
Your Debt Repayment Plan
If you couldn’t tell, I hate bad debt. While I may not know you, I know how disheartening that looming payment obligation every month can be. This is why I want to share with you a line of credit hack I stumbled upon while reviewing my monthly statements. While it may not revolutionize your world for paying down your debt like implementing a major debt repayment plan like the following:
“The Interest Is Compounded Daily”
One month while going through my statements, I started calculating my own interest payments. It seemed like the interest payments were higher than they should have been. After trying a few different calculations to figure out where the higher-than-expected interest amount was coming from and being unable to resolve the discrepancy, I called my bank. It took them saying just one sentence for it all to click: “The interest is compounded daily.”
It all made sense. My calculations were off because I was basing it on monthly compounding. Monthly compounding means you pay interest on the amount that is left over at the end of the month; while daily compounding interest means that you are paying interest on the balance owing at the end of each day. After you make a monthly payment, interest starts building up every day on the interest you owe for the rest of the month until you make your next payment.
For example, say you make your monthly payment. The next day, interest accumulates on the remaining balance. Fair enough. On day 2 after making a payment, you are paying interest on the remaining balance, AND on the interest accrued from day 1. On day 3, you are paying interest for Day 1, Day 2, Day 3, AND the increased interest accrued on days 1 and 2. This pattern continues until your next payment. You are paying interest on your interest, on your interest! Not cool. The banks are a business though, and they have methods for making money down to a science.
The Debt Hack I Stumbled Upon
Admittedly, I was annoyed by this realization to an irrational extent. After all, this is how credit cards work. It follows that the Line of Credit debt works the same way. The effect of compounding interest is immense over time, so the fact that interest was compounding daily REALLY annoyed me. Could there be a way around this?
So I started to think about other debt areas that have compounding interest. Mortgages came to mind easily. With mortgages, accelerating to bi-weekly payments cuts down the cost of interest substantially… Let’s try that. After working out the numbers, it worked out to a few dollars a month saved. Any savings is better than none, but at this point I was on a mission. The word in the statement that triggered my irrational reaction was the key: DAILY!
Daily Payments Are Better than Monthly payments
The only way to get around paying interest on interest from one day to the next was to make a daily payment that at least covered the interest. Problem solved! Paying off the interest daily prevented having to pay a growing compounding daily interest! So instead of a monthly payment, I could make a daily interest payment, and then just make the rest of my lump sum payment at the end of the month.
At this point, I was stoked to have found a way to lower the effect of compounding daily interest. Why stop there? Instead of looking at just paying the interest daily, why not start to pay down the principal daily as well?
Divide and Automate
So, I took the amount of the regular monthly contributions and divided it by 30 to get a daily amount to pay off. Using the “Automatic transfer” feature on my Online banking, I set the payments to every weekday (they don’t do transfers on the weekends or holidays). On Fridays, the daily amount was tripled to account for Saturday and Sunday.
What was the effect? After going through this process, I realized that the balance owing was going down faster for two reasons:
1. the principal decreased each day, and
2. I was NOT having to pay interest on the interest.
The principal owing was shrinking throughout the month. In effect, the interest rate charged each month became slightly LESS than the interest only “minimum payment.” Translation: Paid less for interest than the bank anticipated. This was because of the decreasing principal through the month. Total win!
Now how does this look using real numbers? Well, let’s go back to the “Average Canadian” with $28,155 in debt. With normal monthly payments of $500/month, it takes 84 months to pay off (assuming an 8% interest rate). If you pay the same amount monthly, except divide the payments over the course of the month to a daily amount, it shaves a month off. Again, not a revolution, but a little sooner being free of debt.
The effect increases though as a person’s payments come closer to their interest costs. If on that same $28,155, a person was putting $300/month toward clearing the debt instead of $500, it shaves a couple of months off the total time to re-pay the amount. This method is most beneficial for people who can’t raise their monthly contributions, and are not paying as much of their principal down as they would like.
A Word of Caution
If you decide to make daily debt payments a part of your debt reduction plan it is important to consider your type of bank account. Make sure that your account is set up for unlimited monthly transactions. This will allow you to make the transfers without incurring any additional charges. If you have a minimalist plan that only allows a few transactions a month, the extra fees incurred from more transactions will probably not make it worthwhile. Consider switching to a no-fee account with unlimited transactions.
Setting Up Daily Payments
To make daily payments work for you, there are essentially 3 steps:
- Check that your account is set up for unlimited transactions
- Figure out your daily payment: determine your monthly payment and divide by 30.
- Automate your daily payments. Make sure you triple the amount on Fridays to account for Saturdays and Sundays.
Financial institutions make enough money. Let’s loosen the grip they have on us and use every advantage we can to keep more of our money for reaching our goals! Get that debt down as fast as possible! After that last payment, the lingering, looming cloud that may have been a source of stress for years, shifts into a feeling of celebration, triumph, and excitement! This is my wish for you as soon as possible!
I love your concept and would love to apply to my mortgage so have a few questions. Have you tried this on a mortgage? I don’t think my mortgage provider will allow that as they had a pre-set selection of payment frequency.
My second question is around cash flow. I am paid bi-weekly so I have cash to put towards my debt every two weeks. Doesn’t it make more sense to put as much as posisble towards your debt as soon as you have the cash?
Thanks for bringing up a new way of thinking about debt repayment!
Thanks for reading and the comments! I like your line of thinking! Unfortunately most mortgages have pretty strict guidelines around payment schedules, so I don’t know of any traditional mortgages that would allow it. If any, a Home Equity Line of Credit (HELOC) type of mortgage would be the best bet. Different companies have different levels of flexibility with repaying these types of mortgages. Typically for this type of mortgage though, you are paying a premium of 0.5 to 1% higher a rate than a traditional mortgage to have that flexibility in payments. Off-hand I am not sure if it would be worthwhile given the higher interest rate.
Regarding question 2: If that is what your current schedule allows for then yes, great job! Keep it up! I have no idea how strict your budget is or if you leave a balance in your account. When I made the switch to daily payments I had some buffer room in my account and was able to start the daily transfers immediately after a larger payment. My challenge to you would be to implement the daily payments immediately following your regular bi-weekly payment IF it is feasible to keep up with the payments, and not go into overdraft before your next payday. The real difference you’ll notice in interest charges between bi-weekly payments and daily payments will be very small… but every fortune is the accumulation of many tiny pieces of wealth! 🙂
I tried looking into this with my mortgage company and they are such con artists, of course.. always in the business of making money. They said I had to follow a preset payment schedule as outlined in our initial mortgage agreement. That being said, who’s to stop us from doing daily payments on top of this?? A few bucks here and there surely could make a dent in this massive sum and the interest accrued? 🙂
Yes, they are good at making money indeed! There is usually a bit of wiggle room to add some extra payments, but they often have tight stipulations on the amount of the extra payments and frequency… you know, to make sure they get their share.
Just make sure they won’t be penalizing you for making more payments!
Do you get paid daily? If not, you’re letting money sit in your chequing account while the debt accrues interest and making things needlessly complicated. Paying as much as you can as soon as you can is the key take-away.