After 20 years of financing experience, 3 home purchases and twice as many cars, I’m still surprised from time to time by the veil of easy-money most financing options present.
Though financing is certainly necessary, especially when it comes to emergencies or buying a home or a car, understanding the true cost of financing is key to making the right financial decisions.
Here are eye-opening facts about loans and financing to help keep you out of financial trouble.
Simple Interest Loans
Simple interest loans are easy to understand. You pay a percentage of the amount you borrowed as a fee for the loan.
So for example, if you borrow $100 at 10% interest for 2 year, your payoff figure will be $100 plus $10 for each year, totaling $120.
Easy to grasp, easy to calculate. But the eye-opening fact about loans today is that simple interest loans are unlikely to be the ones you or I will be offered.
Compound Interest Loans
Compound interest loans are more difficult to understand. Typically the first year of the loan is treated as a simple interest loan. So for example, you begin by owing 10% on your $100 loan amount (principal), making your combined debt $110.
However, at the end of the year, the lender compounds the interest on the debt to reflect not merely the amount you originally borrowed, but the total amount you still owe, which is $110.
Therefore, you still pay the 10% interest rate agreed upon, but now you pay it on a larger sum than you originally borrowed. The longer you take to pay off your debt, the more your interest will accrue and with it your compound interest will grow.
The eye-opening fact about loans today is that most Americans are trapped in this compound debt cycle.
Credit Card Banks Make Money from Compound Interest
The longer you take to pay off your credit card loan, the more your compound interest increases in relation to the original debt.
If you wait long enough, you’ll find yourself owing double the amount you borrowed, until soon you’ll be paying compound interest on compound interest from previous years.
This eye-opening fact about loans and financing explains why so many Americans are stuck in the rut of indebtedness. Recent laws have forced credit card companies to indicate a comparative payment option with each monthly statement.
Now you can see how much you must pay monthly to pay off the debt in 3 years, in place of the monthly payment that may take up to 24 years to pay off the debt.
Furthermore, you can see the astonishing difference between the payoff figures for short-term loans and long-term ones.
Car and Home Loans Profit from Compound Interest As Well
To ensure profit even if a loan is paid off early, most lending institutions disproportionately apply your payments to the interest owed rather than the principal.
This ratio is reversed when you reach a mid-point in the loan. This is why most payoffs find it hard to build equity in a new home, since most of their monthly payments go to paying off interest.
If you’re considering refinancing an older loan, take this fact into account. The same applies with car payments as well.
The eye-opening fact about loans is that an amortization schedule can show you exactly how long you’ll be paying interest before you can start making a dent in your principal.
You can ask for an amortization schedule from your lender before you sign the dotted line.
Avoid Compound Interest Personal Loans
Even personal loans are bound by the facts discussed so far. This is especially true when you are borrowing from a credit card company that’s offering you a personal loan with a fixed interest.
Most likely they will apply compound interest to your loan. Don’t be lolled into a sense of security by the promise that no penalties apply if you pay off the loan early.
You will still be bound to pay off the compound interest that was initially calculated for the entire duration of the loan. The bank loses nothing. You lose everything.
Credit unions are a better option for personal loans if you can become a member.