27 Apr The Usual vs. the Optimal Way to Use a Line of Credit
To date, all of my posts have assumed that you have at least $1,000 after you pay your bills. What happens if you only have around $500? I’ve created a series of examples just for you.
My Cash Flow Profile
Let’s assume you deposit just $4,200 each month. You’ve reviewed your budget and after all your bills are paid, you have just $518. You have a borrowed $5,000 from your line of credit that has an interest rate of 5.25 percent. You want to pay off your line of credit in one year.
Review Your Average Daily Balance
Whether you are trying to earn the most or pay the least amount of interest, it’s all about making the most of your average daily balance.
Paying Off Your Line of Credit the Old Fashioned Way
Typically, we don’t worry about our average daily balance. We simply make our monthly payment to our bank. Now that we understand the way our average daily balance is calculated, let’s look at the impact our payment. I’ve created a series of graphs that make this point.
The first three graphs demonstrate the monthly interest payment against the average daily balance, the cumulative interest payments against the ending loan balance and the loan balance against the average daily balance.
Look closely at the third graph; the average daily balance for any given month is always greater than the ending balance of the line of credit. Why? The first half of the month the outstanding loan balance is higher than the loan balance after the $500 payment is made. If you’re thinking to yourself, “Of course and what’s wrong with that?” you’re right! Remember, our goal is to minimize interest payments. Instead of paying $127 in interest, let’s payoff our loan two months earlier and pay just $19 in interest.
Putting Our Income to Work
Let’s continue reviewing our series of graphs. The first two graphs below the heading, ‘The Typical vs. the Current Pay Dates – Summary’, we see the impact when we shift our income but don’t make the most of our average daily balance. We see a significant reduction in the average daily balance. Making this one change enables our interest cost to drop from $127 to $91. But what happens if we also optimize our average daily balance?
Optimizing and Shifting Income Works Best!
The final three graphs dramatically demonstrate the impact of rescheduling payment dates to the end of the month. The first of these three graphs show the average daily balance dramatically lower than the loan balance. The second of the final three graphs show that the total interest cost is just $19. The final graph compares the optimized average daily balance against the average daily balance when the typical methods are used in managing a line of credit. There’s no comparison.
So, when you have just $500 after your bills are paid, does this strategy matter? Definitely! The sooner your debt is paid off the sooner you can use your optimized average daily balance to earn more money 24/7.
Ready to start your journey towards financial freedom? Get started today!
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