Zina Kumok, 26, has learned a thing or two about personal finance – the hard way. When she graduated from Indiana University with a journalism degree, she was saddled with $28,000 worth of student-loan debt that she had to pay off on her own, and on the starting salary of a journalist, which was only about $28,000 a year. Soon after, Kumok launched an online blog, “Debt Free After Three,” in which she regularly posts personal-finance reflections and anecdotes about her journey to pay off her sizable student-loan debt in only three years. Typically, it would take nine years or longer, and cost thousands of more dollars in accrued interest.
Kumok’s last loan payment cleared on November 18, 2014. How did she become debt-free? She says, “There are only two ways to pay off any kind of debt. Spend less or make more. Do one or the other — or if you’re really desperate, do both.”
We featured Kumok in a student-loan article a few months back and decided to invite her to be a regular KWHS contributor. Below is the first installment of a series of articles that Kumok is writing for KWHS about her personal-finance journey. She says she has learned a lot of things that she wishes her 17-year-old self knew before she took out student loans. First up? All about interest.
When I graduated from college, I wasn’t worried about my student loans. I had only taken out $28,000 and felt confident I would get a job that would allow me to make my monthly payments. But when the first bill came, I saw what paying off debt was really like – and I discovered the “interest” money pit. I was paying 6.8% interest on my loans, and more than half of my first payment went to pay off that interest. Let me be clear: This was money that my loan agreement required me to pay just for the privilege of taking out a loan. So, I didn’t really owe $28,000 in student loans. Over the lifetime of my loan, I would actually owe thousands of dollars more than that, all due to interest.
After I saw my first student loan statement, I realized that if I only made the minimum payments on my loans each month (remember, you get charged interest each month that you don’t pay the full amount of what you owe), it would cost me thousands of dollars in interest. It felt like such a waste to blow that much money on nothing.
Shopping at Goodwill
As my story illustrates, interest can feel defeating when you’re the one paying it. So, I’m here to share with you a few things that I wish I knew when I was in high school. What is interest, and how does it work?
Simply put, interest is the cost of using someone else’s money. When you borrow money, you pay interest and when you lend money, you earn interest. The interest rate is the price borrowers pay for the use of money they do not own – like that 6.8% rate on my student loan. The current interest rate on most student loans is 4.66% — and rising.
Interest can be bad if you’re borrowing, and good if you’re investing money. If you open a savings account at the bank – which means you are actually lending money to your bank – you earn a very low rate of interest, usually around 0.06%. So, if you put in $1,000, after a year you will only earn 60¢. Different financial products earn different rates of annual interest – some more than others, often depending on the riskiness of the investment.
Since my most painful experiences with interest are on the borrower’s side, that’s what I want to focus on first. Knowledge is power, and applied knowledge, in this case, could save you thousands of dollars.
Once I saw all the interest that I had to pay each month when I wasn’t able to pay off my student loans, I decided to pay them off quickly. I threw any extra money I had toward my student loan payments. I cut back on eating out, shopping and anything else frivolous and used the money I saved to pay down my student-loan debt – and more importantly, to pay more than the minimum payment each month. I bought clothes at Goodwill and invited friends over instead of going out. It required some sacrifices and a mindset to save, but after three years, I was debt free. Since I paid off my student loans years ahead of schedule, I saved thousands of dollars on interest payments.
I would be wrong to leave you thinking that interest is always an evildoer. Just as interest can be a negative when you are borrowing money, it can work to your advantage when you’re investing. And something known as compound interest is the very best of all. It is a key reason why you should start saving your money now, instead of waiting until you are out of high school and college.
Early Savers Are Rewarded
Compound interest is defined as “interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan.” Compound interest can be thought of as “interest on interest,” and it will make a deposit or loan grow at a faster rate than simple interest, which is interest calculated only on the principal amount. Basically, compound interest allows your money to grow much faster because you are earning interest on the original principal that you invested, as well as on the interest that makes your money grow.
Here’s an example: If you invest $1,000 and contribute $500 every year for 20 years (at a 5% interest rate), you will end up with $20,012.92. If you do the math, your only real contribution was $11,000. The extra $9,012? That’s compound interest. It’s just extra money you earned from holding your money in the same place for 20 years and earning interest on the growth of that money.
Compound interest rewards those who start early. Let’s say that instead of following the example above, you wait 10 years to start investing. You’ll have to contribute $14,000 of your own money to end up with the same result. That’s a difference of $8,000 you have to spend.
As I move through my 20s, I can say without hesitation that saving is critical. Working so hard to pay off my student-loan debt helped me to appreciate the value of saving. It doesn’t matter if you can’t afford to put in 10% of your salary, which is what the experts recommend. It doesn’t matter if $50 a month is the best that you can do. What matters is that you do it – and that you start early. You will always have a reason to spend. But ideally, you should also find a reason to save.
How does interest factor into the equation when you are borrowing money? Zina Kumok talks about interest on student loans. How about credit cards? Read the KWHS “Credit Alert” article in the “Related Links” below and discuss the dangers of paying only the minimum due on a credit-card balance.
What is compound interest and why is it such a good thing?
Are you a saver? If so, how do you determine how much you will save? Discuss saving strategies with a partner and with the class. Use what you’ve learned in this article to consider how you might improve your saving strategy.