Due to the overwhelming response to the forum posting “Why my balance never goes down” we are including some tips on how to recognize problems BEFORE they become the driving force behind your loan.
Identify the term (length of time or number of payments) and the interest rate and accrual method.
Open end or revolving credit payments are based on roughly interest + 2% of the remaining balance. The minimum payment may be reduced as the principal owed on the loan amount goes down. Penalties or fees assessed are added to the principal or the amount owed. Payments are applied to the interest and fees before being applied to the principal.
Fixed end credit payments have a fixed term or end date. Such terms have payments scheduled in a manner that the same amount is paid each month and the loan matures or is paid off within the specified time frame.
Interest rate is a pretty straightforward term. However the accrual method can make a critical difference.
Rule of 78 front loads the interest paid in a manner that creates its own pre-payment penalty. The interest that would have been paid during the financing is calculated so that the financer gets paid most of the interest that would have been paid over the term of the loan during the first part of the loan. If the borrower pays it off early, they are still responsible for the interest that the financer would have been paid over the contracted life of the loan. Do a search on “rule of 78′s” for additional calculators and definitions.
Simple interest: Generally the interest is paid each month on the amount financed. The accrual (when the interest is calculated and added to the account) method or frequency is what has the impact on the payment. Interest may be calculated to accrue daily, monthly (accounting period), or on an average balance for the accounting period. Remember the base line that interest is charged to, is the amount of the loan, however late payments, fees, and interest may be added to the outstanding balance and interest charged on that amount.
Compound interest: Interest charges accrue and are added to the loan principal. Then interest is charged on the original loan amount + the previously accrued interest. With a $2000 loan at 14% interest, the interest accrues at nearly 80 cents per day. This is added to the balance, becomes part of the loan, and interest is also charged on the interest. While interest accruing at 80 cents per day may not sound like much, by the end of the month, it results in an effective interest rate of between 14.5% and 15%.
Before you sign for any loan, compare the information carefully with what you were told by the sales staff. From personal experience: I made a decision to purchase based on information from the sales staff. When I went to sign the loan documents, the payments were nearly identical to the ones I calculated during the negotiations. However the term went from 10 to 12 years, and the interest rate from 8% to 10%. Had I not been diligent in comparing the information, and had signed the loan as presented, the loan would have been 2% higher and the term 2 years longer than expected. I did not sign the for the loan as it was originally presented. In my case, the sales price was adjusted to meet my calculation on the original payment and the term reduced to the 10 years, the changes were made, and new loan loan documents were presented for my signature.
During an investment class, I was introduced to “Rule of 72″. Take the interest rate paid by your investment, divide it into 72 (72/% rate), the resulting figure is the number of years to double your investment by accumulating interest. An investment bearing 5% would take more than 14 years to double its value.
Now reverse it, and see how much time it takes for a finance company to double their “investment”. An example may be using a store credit card promotion, offering no payments and defered interest for 2 years. If the loan is not paid off completely before the expiration of the promotional period, the interest on a $2000 purchase accruing at 14% would result in $480 interest charged. This is simple interest, with no late fees, penalty, or accrued interest in the calculation of the balance.
If no payments or minimum payments were made to decrease the principal, the finance company would double the value of their original investment, your $2000 loan in five years (72/14= 5 years 1 month). When the interest rate is higher, or compounded, and includes any fees, they recapture their investment sooner.