personal loans

Start Taking an Interest in Interest: Personal Loans

Personal loans are a big category, and can vary greatly depending on the type of loan. However, there are some basic things to keep in mind when you are looking at taking out personal loans, and as always, understanding that interest is key to Money Earned through Money Saved.

Technically, everything already mentioned (mortgages, credit cards) are also personal loans, but for the purposes of this post, personal loans refer to smaller amounts of money that will be paid back within a few years.

Thus, we’re talking about things like auto loans, personal lines of credit, home equity loans, as well as any other smaller balance loans. It’s important to remember that terms and conditions, as well as the types of personal loans offered, will vary by financial institution.

The following information is meant to serve as a guideline in helping you to understand the various options out there and how they are impacted by interest.

Auto and Recreational Vehicle Loans

Let’s start with auto and other recreational vehicle loans (boats, motorcycles, RV’s, etc.). Like credit cards, the interest on auto and recreational vehicle loans is calculated daily, so the faster you pay off the loan the less interest you will pay. You may be fresh from reading about credit cards and thinking you’d be in big trouble with interest on an auto loan, but the good news is most loans for vehicles have relatively low APR’s (compared to credit cards).

Interestingly, vehicle loans are very different from credit cards in that the interest rate varies depending on the year of the vehicle. Typically, each lender will have 3 or 4 categories for vehicle years, with a range of interest for each category depending on your credit score and income/debt ratio. One thing to note, the APR will actually INCREASE for older vehicles. For example, take a look at the interest rate table for auto loans from my credit union.

 

 

As you can see, the older the vehicle the higher the APR range for interest. This may seem odd, but there are a couple good reasons for why older used vehicles have higher interest rates. First, the older the vehicle the less it is worth (depreciation) and the less the resale value. This means if you default on the loan and the vehicle is repossessed, it’s unlikely the lender will make their money back by selling it.

The second reason is also simple: lenders want you to buy new cars!

Offering lower interest rates for new car loans gives people an incentive to buy a new car because they may think the interest savings will offset the higher price of the new vehicle.

Don’t be fooled.

You can save a ton of money by NOT buying a new car, so unless you have an outrageous APR on your auto loan you won’t save anywhere near enough in interest to offset the higher purchase price of a new vehicle.

Overall, the interest you pay on a vehicle loan will be much less than on credit cards or mortgages, but that does not mean you should let the lender (or dealership) talk you into taking the maximum loan they’ll give you, along with a longer term in order to fit your budget. The focus should not be on fitting your budget (by any means necessary), but on how long your loan is and how much interest you’ll pay (don’t forget cars only depreciate in value). As with any loan, the longer you’re paying on it, the more your hard-earned money will go to interest. Go for shorter term if you can, and try to pay extra as often as you can to decrease the interest amount even more.

 

Home Equity Loans

Now let’s talk about home equity loans (often called second mortgages). Home equity loans are funds borrowed against the equity in your home. In other words, if you owe less than what your home is worth, you have equity that you can use to access more funds. Borrowing against the equity in your home also means the lender uses your home as collateral, meaning that if you default on the loan the lender can take possession of the home in order to recoup their investment.

Foreclosure is a major risk when borrowing against your home, so don’t overstretch yourself! (The interest rate is very attractive for home equity loans, but DO NOT use your home as an ATM machine!)

Generally, there are two types of home equity loans offered: fixed amount and line of credit. A fixed amount home equity loan is when you borrow a specific amount, and is similar to a mortgage in that you have a fixed interest rate and payment amount. Interest rates for fixed amounts are generally similar to that of mortgages, and the amount you can borrow depends on how much equity you have in your home. The impact of interest will be greater the larger the loan and length of repayment, similar to a mortgage. For example, take a look at this table for a home equity loan of $80,000 with an APR of 5%.

 

 

Even though $80,000 is not a huge amount compared to a mortgage, the amount of interest paid over 10 years is still over $20k. Of course, paying extra toward the principal every month will significantly decrease the interest amount, or paying back the loan over a shorter term (less months). Take a look at the same loan amount over 96 months (8 years). Although the payment is higher, you save over $4,500 in interest!

 

 

Home Equity Line of Credit (HELOC)

On the other hand, a home equity line of credit is more like a credit card. You still use the equity in your home to access the funds and use your home as collateral, but in this case you have a maximum credit line you’re approved for and use it as needed up to the approved amount. As with credit cards, you’ll pay interest on any balance you carry.

Again, use the funds wisely. Do not use this credit line as an ATM for unnecessary expenses. This type of loan comes in handy for purchasing big ticket items, or for paying off items with a high interest rate. For example, you might use a HELOC (as low as 3.9%) to pay of a credit card with a high interest rate (12-16%).

However, this type of loan is different than credit cards in that you’ll generally have a variable interest rate (which could increase or decrease at any time, so watch this). You also may have to pay an annual fee.

No matter what type of home equity loan you’re interested in, the larger the amount and the higher the interest rate the more interest you’ll pay. Also, similar to other loans, the more you pay toward the principal balance, the less interest you’ll pay overall. In general, if the loan amount is small and the length of the loan is short, you’ll pay less interest even if only making minimum payments. However, if the loan is a larger amount and for a longer term, start making extra payments as soon as you can afford to. This will significantly decrease the interest paid and allow you to have Money Saved through Money Earned.

A home equity line of credit is a good option as a backup resource for emergency situations, but should not be used like an ATM.

 

Personal Lines of Credit

Personal lines of credit are just like the home equity line of credit described above, except they are not based on your home equity. You are approved for a line of credit that you can utilize whenever you want up to the maximum amount, at which time you’ll need to pay the balance down if you wish to use more credit. Unlike a line of credit home equity loan, personal lines of credit often have higher interest rates (14-16% APR), which can make them very expensive if you carry a balance (see credit cards). They also typically have a variable interest rate which will change with the changes in the economy. Personal lines of credit are also like credit cards because interest in calculated using the average daily balance. However, unlike credit cards you are not given a grace period to pay off the loan, meaning any balance you carry will accrue interest on a daily basis.

Furthermore, an advance from your line of credit will begin to accrue interest the day you transfer funds even if you don’t use the funds. So make sure you transfer only when you need it.

Personal lines of credit have a high interest rate and no grace period. Therefore, paying a minimum monthly payment is a bad idea, as you’ll end up paying almost as much (if not more) in interest!

 

Smaller Balance Loans

Even though these loans are for smaller amounts, they are worth mentioning because they can still cost you a great deal in interest. These loans are available for any personal use, and are dispersed either to your bank account or as a check. They are for small amounts (ex: $5,000) and for shorter terms (ex: 36 months). They also have higher fixed APR’s (12-14%), which means you’ll pay a lot in interest if you only make minimum payments (just like with credit cards and personal lines of credit). Although these loans have higher interest rates, the shorter term of the loan somewhat mitigates the amount of interest you’ll pay. Here’s an example.

 

 

This table shows that even with a higher interest rate, a shorter-term loan will result in less interest paid.

Moral of the Story

As you can see with these examples of various types of personal loans, there are several factors that affect the interest you’ll pay.

The first is the APR, or interest rate. The higher the rate, the more you’ll pay in interest.

The other is the length of the loan. The longer the length of loan, the more you’ll pay in interest. Thus, a loan that is longer term but with a lower interest rate may yield similar interest amounts to a shorter-term loan with a higher interest rate.

Each loan is different, and should be considered individually based on the terms. However, one idea is constant: making extra payments. Making extra payments toward the principal will pay down the balance faster and greatly reduce the interest paid, no matter the terms.

Bottom line, the less you borrow and the quicker you pay it back, the more you’ll save on your borrowed money.

Talk about Money Saved.

 

 

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4 thoughts on “Start Taking an Interest in Interest: Personal Loans”

  1. Sam@ Thiswaymommy.com
    Wow talk about awesome financial tips! Thank you for breaking it all down. I love posts like these which teach us the best way to manage our money!

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