Credit profile: Sasha
Sasha has always been frugal and has saved up her money for a down payment on a beautiful condo near her job. The condo will cost $250,000 and Sasha has saved enough to pay 20% down and all the fees associated with the sale. She visits the bank and finds out that she is approved for a loan for the remaining $200,000, and based upon her good credit, will only have to pay a 6% interest rate
Sasha is very happy until they tell her the monthly payment will be $1,200 for the next 30 years. She quickly multiplies $1,200 times 30 years times 12 months in a year and it comes to $432,000 to pay off a $200,000 loan! How can this be?
Sasha would like to calculate this out for herself, but does not understand how interest works. Let’s work through the first month’s payment and see how this works.
Annual interest rate = 6%/year. The monthly interest rate (annual rate /12) is: ______
How much interest is included in her first payment: (monthly interest rate x $200,000): ______
How much of her first payment goes to pay off the loan (payment—interest): ______
How would you calculate the second month?
How interest works:
Like Sasha, if you were buying a house you might need to borrow $200,000 or more through a home mortgage (loan) from a bank or credit union. In order to make the monthly payment on the loan affordable, individuals usually take 30 years to repay it. Based upon this, the bank would determine the interest rate you need to pay (6% in this example) and would calculate your monthly payment ($1,199.10).
Every month, you would pay this amount to the bank or credit union. At first, the payment would almost entirely be for the interest, but over time you would gradually reduce the amount you owe the mortgage company (loan balance). Because the amount you owe decreases over time, the amount of interest in each payment also decreases.
The following table shows how this would work with the above example. In general, it takes about € 2 3 the length of the mortgage to pay off half of the original loan amount. You will also notice that you pay more in interest than the original loan. Getting the best interest rate possible (largely determined by your credit score) is important to reduce the amount of interest and your monthly payment.
Time Total Paid Total Interest Loan Balance
5 years $71,946 $58,055 $186,109
21 years $302,173 $202,051 $99,877
30 years $431,676 $231,676 $0
Example of the impact of interest
Let’s use the example of buying a new car. Assume the car will cost $20,000 and you want a loan to pay for it over three years. Your credit score will have a great impact upon the interest rate that you will pay on this loan. If you have a lower score, you will pay a much higher interest rate. This, in turn, means a higher monthly payment and you will pay much more over the course of the three years. In the following example, a person with excellent credit will pay $1,901 in interest over three years while a person with poor credit will pay $6,290.
3 Year - Auto Loan - $20,000
FICO Score Interest Rate Monthly Payment Total Interest Paid
720-850 6% $608 $1,901
690-719 7.6% $623 $2,430
660-689 9.6% $642 $3,096
620-659 13.4% $678 $4,391
590-619 18.1% $724 $6,077
500-589 18.7% $730 $6,290
Payday loans are essentially short-term loans. You write a check for the loan to the payday lender, they hold it until a specified time in the future and then cash the check. Payday loans were originally set up to help people who needed emergency money before their next paycheck. Because their credit rating was poor, they often could not get a loan from a bank. Instead of going to a loan shark, they were able to go to a payday loan outlet and get a very short-term loan to help them until their next paycheck.
Interest rates and fees were very high, but if used in a true emergency, it was a valuable service. The difficulty for some people is that they get in the habit of obtaining loans on a regular basis. Each loan renewal covers their previous loan and they are locked into a cycle of increasing debt and very high fees.
In 2007, Oregon law was changed and set the maximum interest rate a company can charge at 36% per year, with loan fees of 10% of the loan amount up to a maximum of $30. In Washington, the maximum fee is 15% on the first $500 and 10% above $500. Note this is a fee and not an annual percentage rate.