Tuesday, January 10, 2012

Car Loans & Interest Paid

Do you remember the days of “add-on” interest?  As I recall, this is the way it worked.

If you borrowed $5000 on a car when you bought it, and you happened to ask the interest rate you were going to pay (remember that most buyers did not ask this question, but only lumped the entire cost of the car into “what will my monthly payment be?”), you were told it was 10%.

The problem with only the 10% interest concept is that the 10% was added on at the time of sale based upon the gross price of the car, not the average amount of debt you would have in the car loan over its payment period.

Let me give you an example of how “add on interest” worked.  If the car cost $5000 and you were going to pay for the car over three years, the interest of 10% per year was added on at the initial time of purchase.

10% times three years is 30% - 30% of $5000 for the car is $1500.  You add $5000 cost to $1500 interest ($6500) and then divide that into 36 payments.  Each payment is $180.55.  This is not interest at 10%, it is interest at 15%.

If you were paying 10% on the declining balance rather than 10% on the initial cost, your monthly payment would be $159.72 or really 10%.

The difference between what you pay and what the lender receives from add-on-interest is $749.88. 

In 1955 I bought a new car.  I was 17 years old.  I looked at the purchase price, asked the dealer what my monthly payment would be and when I knew I could make the payment I bought the car.

A year later, while sitting thinking about the deal, the light went on.  I told my father what an idiot I had been for not understanding the real interest cost and he simply said, “I wondered how long it would take you to figure it out.  Let that be a lesson on how to handle your money.”

Take a look at your own loans of every kind and see what the cost of those loans is by the time you add interest, fees and costs.

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