For all people shop around for the best rate, there are few who have taken the time to sit down and add it all up. After all, why would you bother? The answer is that understanding just how interest rates work can help you see how important small differences in rates and payment amounts can be.
Interest Rates are Compound.
It is important to remember that what you owe is compounded – that means you pay interest on the interest you owe from the month before. That means that if you’re paying 2% per month in interest, you’re not paying 24% per year – you’re actually paying 26.82%. Charging interest monthly instead of yearly is a trick to make it feel like you are paying a very low price for your borrowing.
A Thought Experiment.
Here’s a question: would you rather have $1 million, or $10,000 in a savings account earning 20% per year in compound interest?
Well, let’s see how that $10,000 would grow. After 10 years: $61,917. 20 years: $383,375. 30 years: $2,373,763. 40 years: $91,004,381. 50 years: $563,475,143.
So after fifty years, you’d have over $500 million?! Well, not so fast. Of course, you have to take inflation into account – if we say inflation is 5%, then that money would have the buying power that $10,732,859 does today. Still, that’s not a bad return on your investment of $10,000, is it?
That’s the power of compound interest, and the way the credit card companies make their money (it’s also the way pensions work, and the reason the prices of things seem to rise massively as you get older). Be very, very afraid of compound interest. Or, of course, you could start saving, and be very glad of it
Compound Interest Adds Up.
Let’s work through an example on a more real kind of scale. Let’s say you have an average unpaid balance of $1,000 on a card at 15% APR.
You will owe $150 in interest for the first year you borrow. However, this amount is then added onto the balance, and interest is charged on that. The second year, you’d owe another $172.50, for a total of $1322.50. It goes on, with totals like this: $1,520.88, $1,749, $2,011.35.
After just five years at 15%, you’d owe double what you borrowed. And after 10 years, you’d owe four times what you borrowed! Bet you weren’t expecting that. If you let something like that carry on for long enough, you’ll end up paying back that credit card for years afterwards, paying back what you borrowed many times over and still not clearing the debt. Most people don’t work this out, and feel that the payments must simply be their fault for spending too much money to begin with.
One Percent of Difference.
One more thing. You might think there’s not that much difference between a card that charges 15% APR and one that charges 12% APR. Let’s see the difference the lower rate would make to that $1,000 borrowed for five years. Remember, after five years at 15%, you owed $2,011.35.
At 12%: $1120, $1254.40, $1404.93, $1573.52 $1762.34 after five years. So you’ve saved $249.01 from that 3% difference in APR – in other words, you’ve paid almost 25% less interest.
Points seem like a good idea, after all, the interest rate is lowered. But if you don’t have cash on hand in advance, paying points can seem just out of reach. Do you need to pay points?
For most people, paying points just doesn’t make sense.
A point, often called a discount point or origination fee, is equal to one percent of the loan amount. Points are paid to the lender at the time of closing.
By paying points, you are buying down your interest rate. The more points you pay, the lower your interest rate. Lenders started offering points in the early 1980’s when mortgage rates were 15%. The housing market just went dead as people were unable to afford such high interest rates on mortgages.
To stimulate business, lenders offered discounted rates with fees attached, called discount points. Many sellers began to pay the points charged by the lender in order to sell their home. This gave the buyers an affordable mortgage and owners were able to get their homes off of the market.
But times have changed. Interest rates are no longer anywhere near 15% on mortgages — they are more like 7%. The need to fork out a ton of dough in order to get a lower rate isn’t really there for the average home buyer.
Let’s look at the numbers. For example, you find a 30 year fixed rate mortgage at 6.50% with two points. For the life of the loan, you have a fixed rate of 6.5%. But you will have to pay the points at closing. If the home you want to purchase is $192,000, you will have to find an extra $3,840 at the closing to cover the points.
Another lender is offering you a 7% interest rate on the same mortgage.
Which deal is better for you?
You put the standard 20% down on the loan. The monthly payment and interest payment for the 6.5% mortgage is $1,207. The 7% monthly payment increases to $1,270 per month. That’s a difference of $63 per month. If you divide the $3,840 by $63, you will find that it takes 61 months, or five years and one month, to recuperate your points in the form of a lower payment. This is your payback period.
You could put that $3,840 in the bank to earn interest. If your bank is paying three percent interest, you would earn approximately $10 per month. If you pay the points, you are loosing money that you could have made interest on. So, subtract $10 from the $63 savings. Now divide $53 into $3,840 and you will find that the payback period increases to 72 months, or six years.
So you have to stay in that home with that particular mortgage for six years to make back the money you pay in points. Most people won’t stay in a home for over six years today.
And with rising home costs, many home buyers don’t have the extra cash on hand to pay the down payment, closing and points. That’s why many lenders have started offering lower down payment mortgages — they understand how hard it is to save that money.
If the seller wants to pay points, that’s great and extremely rare in today’s market. If you aren’t positive that you will stay in the home long enough to recuperate the cost of your points, it would be best to choose the mortgage without points.
Most people, even those without debt, have a hard time saving money.
The plain truth is that most people will spend all of their money every month. They grow to become used to this spending level. It is very, very difficult not to do this.
Financial advisors say it over and over again — you have to pay yourself first. It is the truth. Those of you with 401(k)s don’t miss that money being automatically taken out of your paycheck. You never see it, so you don’t miss it. That is the idea of paying yourself first. If possible, have your employer deposit a portion of your paycheck each month into your savings account. Or perhaps your bank will automatically withdraw that amount from your checking to your savings each month. You never see the money and you don’t have to make any effort to save. It is perfect.
If you pay yourself first, you won’t have a chance to spend the money. When you sit down to write bills out, don’t pay the mortgage first. Pay your savings and then pay your bills. See, most people pay their mortgage, cars and other loans first. Then they pay the electric and water. Then they pay what they can on their credit cards. Whatever is left over is spent on living, gas and food.
Then there is nothing left to save. If you wait to pay your savings last, you probably won’t pay it. You must pay yourself first. Write a check to your savings first, then pay the bills.
We lose a lot of money in just pennies each month. One of the best ways that my husband and I save money is to never spend our change. In fact, every night we dump out our wallets. Anything less than a ten goes in the money jar. It is surprising how in just a month, that money really accumulates. We’ve used the money like a small emergency fund. We grocery shop on it when money is tight or we treat ourselves to a nice evening out. It is an easy way to save.
Another version of this is to put the change you get back from any drive-in in an envelope in your glove box. Do this whether the change is one dollar or ten dollars. When you clean out your vehicle, you will be surprised at how much has accumulated. In fact, it could buy you a tank of gas every once in a while.
When you spend, you can save money as well. Purchase items that grow in value. Extra money lying around? Invest it in the stock market. Invest it in paying off your mortgage early. Use it in ways that make you money. Pay off your debts and invest the rest.
When you save money, the key is to really save it. If you buy something on sale, what happens to the money you saved? You probably spent it on something else. Nothing really went into savings. From now on, when you save $15 on groceries, put that $15 in your savings account. When you don’t buy a new sweater because you know you need to save, put the cost of that sweater into your savings.
Saving money isn’t that hard. It is simply a habit that has to be learned. Experts say it takes two weeks to make an action a habit. So start today, in two weeks it will be easy.