Learning how to avoid the debt trap


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Learning how to avoid the debt trap

Maybe the first rule to learn on how to avoid the debt trap, is to be selective in who you listen to regarding mortgages. A recent article in a newspaper quotes an Ontario grade 12 Economics teacher’s confusing referral to compound interest.

This teacher needs a refresher course in mathematics. He suggests compound interest is a good place to start in teaching students money skills and then goes on to talk about the bulk of the interest costs being paid up front, incorrectly implying compound interest has something to do with this phenomena. The first interest calculation for the first month is based on the outstanding balance which is the initial loan. If the monthly payment is just covering the interest then obviously interest costs are horrendous at the front end. To be perfectly clear, compound interest has NOTHING to do with the bulk of the interest costs being upfront. His mention of compound interest is very confusing and misleading, especially to novice students.

Automobile loans, personal loans and mortgages as just “loans” because they are all calculated the same way. The only difference is the numerical value of the interest factor.

First of all, compound interest is never charged on any loan if the blended payments are made on time. Compounding by definition is growth upon growth. The only time compound interest is charged on a loan is when a payment is late or missed. The interest owing is added to the balance and then next month the interest calculations are based upon interest calculated on an outstanding balance plus interest. From that point on you are paying compound interest on your loan, by definition.

If your payments are made on time, the only person making compound interest on your loan is the lender if he reinvests your monthly loan payments at the same interest rate to someone else each month. The type of compounding determines the value of the interest factor used to calculate how the lenders money will grow in a compounded manner. This is where the confusion starts.

In the legal documents, Canadian mortgages have the confusing phrase, “semi-annual compounding, not in advance” always following the annual interest rate.
The “semi-annual compounding” designation determines the value of the interest factor and therefore how the lender’s money will grow if he invests each monthly payment he receives from you at the same interest rate to someone else. The “not in advance” only confuses people. It serves no purpose because no sane person would pay interest in advance! Only principal is paid in advance in order to save on interest costs.