Know the way loans work…and use it to your advantage!
Every banker knows that the majority of the money they make on a loan is made in the first few years of the loan. By understanding this fact, you can greatly reduce the amount you pay when buying your house, paying off your student loan, or buying a car. Here is what you need to know:
Your payment never changes
When you obtain a loan, the components of that loan are interest, the number of years to repay the loan, the amount borrowed, and the monthly payment. Assuming a fixed rate note, the payment never changes. Here is an example of a $250,000 loan.
It is important to note that your payment in month one is $1,158 and your monthly payment thirty years later is the same amount…$1,158.
Each payment has two parts
What does change every month is what is inside each payment. Every loan payment has two parts. One is a payment that reduces the amount of money you owe, called principal. The other part of the payment is for the bank, called interest expense. Now look at the component parts of the first payment and then the last payment:
So, while your monthly payment never changes, the amount used to reduce the loan each month varies DRAMATICALLY. Remember your total cost of borrowing $250,000 includes more than $166,000 in interest!
Use the knowledge to your advantage
Here’s how you can use this information to your advantage.
For new loans
For existing loans
Final thought
When you make a prepayment on a loan, reduce the loan balance by your prepayment, then look at the amortization table. See how many payments are eliminated with your prepayment and add up all the interest you save. You will be amazed by the result.
How to tell the difference
Not all debt is created equal. Knowing the difference can change the way you look at your spending.
Good debt adds value
Good debt often leads to financial growth, because the product or service being purchased adds more value than the debt that comes with it. Student loans are usually an example of good debt because the related education allows you to earn more income.
Some purchases result in value more directly. Taking on a mortgage, for example, can be valuable simply by giving you access to a place to live all while building equity. Additionally, a mortgage is often considered good debt because your property can be used as collateral for other debt once you’ve made some payments on it, or your home has gained in market value. Even better, good debt often comes with a tax deduction on the interest you pay on things like your mortgage or student loans.
Bad debt adds expense
Credit card debt is almost always bad debt. Not only are interest rates on credit cards higher than most other types of debt, but most purchases made with credit cards are for things that do not contribute to personal financial growth. In fact, interest expense is so high that credit card companies are now legally required to display the cost of this debt directly on their billing statements. Auto loans are another example of bad debt, because cars usually lose value quickly, often leaving more money owed on the debt than the car is worth! But even good debt can turn bad if there is too much of it. Take out too large a mortgage and you may struggle to make payments!
Debt always means higher cost
Debt’s big benefit is allowing you to pay for something over time. The cost of any purchase using debt MUST include the interest expense of taking on that debt. You can compare that with the option of saving up money and then making the purchase without interest. Is the extra interest worth the benefit? Comparing the cost of the purchase with interest, to the value you stand to gain by purchasing the asset, can help you determine whether using debt is a good or bad choice for you.
Final thoughts
Here are some ideas on how to manage good versus bad debt.
Reach out for help if you aren’t confident whether a potential debt will be beneficial or harmful. Making the right choice could save you money.
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