The Fog of Loans 3
Business: it’s what makes the world go round. Corporations are extremely deft at constructing and controlling socioeconomic devices to influence/control people’s behavior for their financial benefit. And one common strategy is to shroud the rules in obfuscation (i.g. fine print, read sub-prime mortgage). Personally I’m an advocate for furthering the average citizen’s understanding of all things finance. (And I think business should have this same interest because it will ultimately lead to fewer people defaulting or declaring bankruptcy.) Loans are one of such devices that I am talking about. Though potentially a necessary evil loans get us into the cars of our dreams and you need to understand them.
Way back in the day it was the norm to pay for a car with cash up front. Pure and simple. Now the norm is to borrow against the future, your future, and your anticipated earnings. Banks issue the loan as a service and charge a fee for fronting the full value of the car. This fee is measured as an interest rate expressed as a percentage. Percentages used to be simple to understand and is a basic curriculum topic in junior high. But percentages become somewhat of an intangible in the world of lending due to words like “compounding” and “amortization.” But the car dealership from where you want to buy your next new car is very well versed in this financial parlance. And due to the adversarial nature of price negotiations, a car salesman will take advantage of any disparity between their and your familiarity of how lending works. Don’t let this happen to you.
For your consideration: loan scenario A and B.
Loan amount: $ 20,000
Term: 48 months
Interest Rate: 5 %
Monthly Payment: $ 460.58
Total of Payments: $ 22,107.84
Loan amount: $ 20,000
Term: 48 months
Interest Rate: 10 %
Monthly Payment: $ 507.25
Total of Payments: $ 24,348.00
Deception
When you are done paying off loan A (assuming minimum payments, always) the car will be paid off and the bank will have received $2,107.84 for their services. (For those sticklers our there, I’ll be ignoring inflation etc.) This is more than 10% of the loan principle (amount of money fronted). So on a loan with a 5% rate, the bank gets more than 10%…deception! I believe loan scenario A to be almost unrealistically good and loan scenario B is a bit closer to reality. After loan B is paid off the bank has received $4,348.00, nearly 22% of the loan principle. This highlights the geometric trickery of finance. The interest rate from scenario A to B doubled, but the bank more than doubled their money. (Use this as extra motivation to negotiate a better interest rate when purchasing your next car.)
Extra Payment
You are not restricted to paying the minimum amount on a monthly loan payment. In fact it is a fantastic idea to pay 150% or even twice the payment amount. Because every cent above and beyond the monthly payment goes straight to paring down the principle. (And spares you from paying interest on that portion of the principle.) Unfortunately it’s typical for the value of a car to depreciate faster than the principle is paid off. An extra payment here and there will help you keep pace (or get ahead) of depreciation. This is very important if you plan to sell the car before the full term of the loan. Otherwise you will need cash to cover the gap between the principle and your car’s value. (Or you can roll that debt into your next loan, but that just perpetuates the problem.)
Down Payment
My advice: when buying a car always put at least 15% down (or more if possible). You won’t pay any interest on that money because you’re not borrowing it. The monthly payment will be lower and put less of a strain on your budget.
Conclusion
If you want to make a lot of money go to college and study accounting.
With a four year loan at 8.17%, a Porsche 911 GT2 only costs $4,751.60 … per month. Sign me up.
