Wednesday, May 12, 2010

Loan Calculations

I seem to be in a financial clean up mode lately. First, I started converting all my paper bills and documentation to electronic form. Now, I’m taking on our debt. I pay off our credit cards in full each month, so typically the only debt I have is my home mortgage. But, last month, we bought two new cars. Prior to that, we had been car-payment free for several years. In all honesty, the idea of having two car payments makes me a little uncomfortable. That’s $900 a month of expenses I didn’t use to have that I now do. I’d love to go back to not having any car payments.

We recently got our tax refund – almost $10,000. Normally it’s never that big, as I don’t believe in giving Uncle Sam an interest free loan, but I spent most of last year working as a self-employed, independent contractor so I was able to take advantage of some nice deductions, the biggest of which I think was my mileage deduction for commuting. I’ve got a 66 mile round trip commute, so that really adds up over a whole year. My first thought was to put the refund towards my car loan. This loan amortization calculator is really nice in that it gives you options to add a couple different types of extra payments to the mix and show you how they will affect the loan. By applying my tax refund to the loan, I will shorten the length of the loan by almost two years (it’s a 5 year loan) and I’ll save about $1,500 in interest charges. Nice.

Then I went to lunch and another thought struck me while eating. I had just made a hard money investment that was earning 10%. I had some additional money saved up in a bank savings account. Maybe I could combine my savings with my tax refund and invest that and then use the income from that to pay my car loan. That’s the basic tenant of passive income – have your money work and make your payments for you. I did some calculations and discovered that, in order for investment income at 10% to cover my car payment, I’d need to invest close to $55,000. That’s a bit more than I have available, so this option is out. (Although my car loan is at 4.25% and I could invest at 10%, I’d need to invest a lump sum of more than twice my loan balance to cover the loan payment because my loan payment includes amortized principle repayments, whereas my passive income would be interest only payments.)

Back to the original plan. Paying off my car loan two years early is nice. It still means I’d have a car payment (two actually, since my wife has a new car too) for at least three years. I just couldn’t really get too excited about this.

Then I started looking at our budget. I’ve been using this great iPhone app called iReconcile for a couple of months now and I’ve also been meticulously categorizing each expense I have. The result is that I have a couple months worth of actual expense data I can look at and report on. I ran through our budget numbers and saw we’ve still got a decent cushion in our income, so I should have no problems sending extra money towards our car payments. Then another thought struck me. We are currently budgeting 15% of our income towards savings. Been doing that for years. We’ve got a nice size emergency fund built up now that should be able to cover us for several months should either my wife or I lose our job. What if, in addition to putting my tax refund towards the loan, I also redirect that 15% from savings towards my car payment? Using that nice amortization calculator again, I saw I could have my car paid off in 11 months!! And I’d save over $2,300 in interest!! Wow! And after my car was paid off, I’d switch to sending that money towards my wife’s car loan in addition to her regular payment and her loan would be paid off in the following year! Awesome!! And, carrying this further, I figure that after two years of doing this, I’d be well-versed in making due without the money I had been sending to the loans, so I’ll keep sending the money off – to my savings account this time. I figure I’ll be saving close to $2,000 a month. After doing that for a while, I should have a nice chunk of change to invest in hard money lending at 10% (hopefully the return will be back to the more normal 12% by then). I’ll build that nest egg up so the next time we need to buy cars, we will be able to use our passive income to pay for them!

There is a drawback to this plan – I will not be putting any money towards savings for two years. As I mentioned earlier, I’ve already got a several month cushion built up, so I’m comfortable with that. Furthermore, the extra loan payments are voluntary. If I suddenly run into a situation where I need to start saving again, I can just stop sending the extra payments in to the loan. Lastly, my wife works for Arizona State University. Due to state budget cuts, there is a good chance that if the one cent sales tax increase that will be voted on next week does not pass, she will lose her job due to the Draconian cuts that will have to be made in education spending at all levels. The general consensus is the tax will pass, but I think I’ll wait a couple days to make sure before I start sending any money anywhere.

This isn’t probably exciting for many readers, but it is for me. I feel like I am *that close* towards finally having enough passive income to pay for something big. This is a goal I’ve been striving towards since I started this blog almost 6 years ago. I also am starting to see and feel the “snowball effect” of saving and investing. It takes a long time to get a good chunk of money saved to generate any kind of significant passive income, but once you get there, things just start growing faster and faster.

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