Sponsors Spotlight: Know How Loans Work and Use It to Your Advantage
Every banker knows that the majority of the money he earns on a loan is made in the early years of the loan. By understanding this fact, you can significantly reduce the amount you pay when buying your home, paying off your student loan, or buying a car. Here’s what you need to know:
Your payment never changes
When you get 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 ticket, the payout never changes. Here is an example of a loan of $ 250,000:
It is important to note that your first month payment is $ 1,158 and your monthly payment 30 years later is the same amount… $ 1,158.
Each payment has two parts
What changes each month is what’s inside each payment. Each loan payment has two parts. One is a payment that reduces the amount of money you owe, called a principal. The other part of the payment is for the bank, called the interest charge. Now look at the building blocks of the first payment, then the last payment:
So, although your monthly payment never changes, the amount used to reduce the loan each month varies widely. Remember, your total cost of borrowing of $ 250,000 includes over $ 166,000 in interest!
Use knowledge to your advantage
Here’s how you can use this information to your advantage.
For new loans
- Only take out loans that allow you to make prepayments without penalty.
- When you borrow money, keep some of your money in reserve. Try to reserve a minimum of 10-20% of the amount borrowed. So in this example try to reserve $ 25,000 to $ 50,000 in cash.
- Immediately after getting the loan, consider using the excess cash as a prepayment on the note. By doing this, you can dramatically reduce interest charges over the life of the note, while keeping your payment constant. Even though your monthly payment may be a little higher, the additional payment amount will pay off the loan faster.
For existing loans
- Create and view your loan amortization schedule. This table shows how much of each payment is used to pay off the loan balance and how much is owed to your lender as interest. In the example above, 67% of the first payment goes to the bank, while only half of 1% of the last payment goes to the bank.
- You pay more than the bank. Aggressively prepay any loan until more of each payment comes back to you relative to the bank. This is the crossover point of your loan.
- Find your sweet spot. After reaching the crossover point, then examine the effectiveness of each prepayment and determine when you consider your prepayment ineffective. No one would consider prepaying that last payment when the interest expense is only $ 4. But what if more than 25% of the payment goes to interest? Continue to make advance payments.
When you make a prepayment on a loan, reduce the loan balance by your prepayment, then look at the amortization schedule. See how many payments are eliminated with your prepayment and add up all the interest you save. You will be amazed at the result.
– By Nancy J. Ekrem, CPA
PC of the DME CPA group
Certified Accountants and Business Consultants