This article was written by Matthew Muir, PE, LEED AP BD +C. Matthew is a 2006 graduate of Ohio Northern University and currently works as a Mechanical Engineer at Advanced Engineering Consultants. As Matt’s college roommate, it didn’t take me long to realize he was very savvy with his finances. After all, he was teaching me about Roth IRAs shortly after we had just turned 20! He has some good points for us all to consider as we think about taking on any loan. If you have any questions about his article, feel free to comment on the blog or e-mail him directly at firstname.lastname@example.org
Quantifying debt can be challenging. You just graduated from college, purchased a home or took out a car loan. If you haven’t been reading Your Financial Pharmacist’s blog and saving up for a long time, you probably don’t have the cash flow upfront to fund a large purchase. For the sake of discussion, let’s assume you go to the bank and take out a 5-year loan for $25,000 to buy a new car. The bank hands you a check and you walk out the door with $25,000 in debt, right? Not so fast.
I’m going to challenge you to think a little differently. From now on, quantify debt by taking into account the total amount of money you will pay over the term of the loan, not just what you borrowed. Ready to get started?
Let’s look at the numbers. Go to www.carloancalculator.me and plug in the following numbers:
Loan Amount (Balance or Principal you Owe): $25,000
Interest Rate: 6.0%
Term (Months): 60 Months
Before we start drawing conclusions, let’s talk a little more about how loans work. When you make your monthly payment, the bank divides your payment up into two categories: principal and interest. The principal is applied toward the balance of the loan ($25,000 in this case) and the interest goes into the bank’s pocket. The first payment of any loan is the most depressing one; you pay the most interest you’ll ever pay and the least principal you’ll ever get credit for (per monthly payment). Look at the numbers:
Payment #1: $483.32 (principal: $358.32, interest: $125.00)
Bottom line: $358.32 of the $483.32 goes toward paying off your loan, that’s only 74.1%
Payment #60: $483.35 (principal: $480.95, interest: $2.40)
Bottom line: $480.95 of the $483.32 goes toward paying off your loan, that’s 99.5%
Yikes! If you paid the minimum payment for the life of the loan (5 years) than you would have paid a total of $28,999.23 (principal: $25,000, interest: $3,999.23) for your new car, which means you paid 16% more for the car than the dealership was charging. $4,000 might not seem like a lot of money to some, but keep in mind the loan amount and the term we looked at. Imagine what those numbers might be on a $250,000 house loan over 30 years. Scary, isn’t it?
Loan Amount: $250,000
Interest Rate: 4.0%
Term (Months): 360 Months
Monthly Payment: $1,193.54
Total Interest Paid: $179,673.77
Loan Amount + Total Interest paid: $250,000 + $179,673.77 = $429,673.77 (that’s not a typo)
Seeing that number makes me sick. (Hold on for a minute while I locate the nearest trashcan!) By showing you these numbers, I’m not trying to discourage you from buying a house or borrowing money for a purchase, but instead trying to encourage you to pay off your loans quickly to minimize the extra money paid in interest so you can keep more of your hard earned money. How do I do that? I’m glad you asked. The good news is that you are already on your way.
- Know how much money your borrowing, for how long and how much it’s going to cost you if just pay the minimum amount over the full term of the loan (we covered this today). Shop around for the best interest rate. Credit unions can sometimes offer a better rate than a larger bank (less overhead).
- Don’t pay just the minimum payment. Start by rounding your payment up every month. In my new car example, round $483.32 up to $500.00. You won’t miss the additional $17.00 per month, and at the end of the first year you will have paid an additional $204 toward the principal on the loan. If you can, increase the amount you pay even more.
- Stick to your budget regardless of what income comes in. Did you get a raise or bonus, a birthday gift, or find cash on the ground? Instead of looking at that money as “I wasn’t planning on receiving this money so I might as well spend it.” Use that extra money to pay off your loan quicker.
- Take advantage of the months where you get an extra paycheck. If you get paid bi-weekly you will get 26 paychecks per year; 10 months you will get 2 paychecks per month and 2 months you will get 3 paychecks per month. Use the extra paycheck to pay off your loan quicker.
- Consider setting up automatic bi-weekly payments (of half your monthly payment amounts). This is a similar principle to what was discussed in item #3. You will actually end up paying extra in principal per year just as a function of how the payment math works out.
- Look for opportunities to refinance and consolidate your loan. (Your Financial Pharmacist Comment: This is a big one right now with many student loan borrowers having interest rates on loans in the 6-8%. More to come on this topic in the near future).
- Ask for a lower interest rate. Never hurts to ask right? The worst they can say is no.
- Cut expenses. Look for financial areas where you can make sacrifices. Cancel memberships and services that you are not using. My wife and I cancelled cable and were able to save $50.00 per month. We use Netflix, an antenna and YouTube and haven’t missed cable at all. Okay I lied, maybe a little during football season. Go Ravens!
This is not intended to cover all the details about loans or to make you an expert. It’s important to do your research to ask the right questions while applying for a loan. What are the right questions to ask while applying for a loan? I’m glad you asked. Maybe Your Financial Pharmacist will invite me back to answer that question.
If you are reading this and have any other ideas about ways that to pay off a loan more quickly, please share your suggestions in the comments sections.