When it comes to taking out a loan, interest rates and terms make all the difference. Don't be fooled by monthly payments -- what matters is the total cost
We humans do strange things. We hit the elevator button several times, believing it will speed up the process. We check for bad guys hiding in the closet and behind the shower curtain as soon as we enter a hotel room. And we worry more about our monthly payments than the total amount a loan will cost.
That last one is straight-up silly. Paying more than necessary for a loan is like throwing money into a fire and watching it burn.
The new car
Loan terms matter, no matter what you're shopping for. For purposes of illustration, let's say you're on the hunt for a new car and fall in love with one in a dealer's lot. The salesperson mentions the price and you swallow back your surprise. It's several thousand dollars more than your cool-headed research from home told you it should be.
The salesperson insists that the number you've run across online is the manufacturer's suggested retail price -- and that demand for this particular model is so high that people are willing to pay much more.
You wisely turn to leave, but the salesperson stops you and asks what your ideal monthly payment would be. You are invited to have a cup of coffee while the salesperson speaks with the finance department. A few minutes later, miracle of miracles, you're informed that the dealership wants your business so much that they're willing to offer you special financing. In fact, they've crunched the numbers and were able to "get close" to your desired monthly payment.
By now, you've imagined driving the car off the lot and are emotionally committed. You don't worry that the annual percentage rate (APR) the dealership offers is 1% higher than you expected. How much damage can 1% do?
They also tell you that you'll need to stretch the loan out over 72 months in order to keep your payment down. You were hoping for 60 months, but decide you can live with a longer loan.
You want that car so much that you agree to terms without crunching the numbers and without thinking about how much you will pay in total.
The difference a percentage point makes
Take a look at these comparisons of different interest rates on a 60-month and 72-month auto loan for a $36,000 car. If you take out an auto loan for 6% over a 60-month period, you'll pay a total of $41,759 -- with $5,759 in interest charges over the course of the loan.
But if you agree to 7% instead, you'd pay an additional $1,012 in interest. And, if you extend that same loan for an extra year at the higher rate, you might lower your monthly payments, but you'd pay a total of $44,191. That's almost $2,500 more than the total cost of the five-year loan at 6%.
Charts like these might help you walk away from bad deals. Each shows how much more a single percentage point will cost you over the life of a loan.
60-month loan
|
Interest Rate |
Monthly Payment |
Total Interest Paid |
Total Paid |
|
4% |
$663 |
$3,780 |
$39,780 |
|
5% |
$679 |
$4,762 |
$40,762 |
|
6% |
$696 |
$5,759 |
$41,759 |
|
7% |
$713 |
$6,771 |
$42,771 |
|
8% |
$730 |
$7,797 |
$43,797 |
|
9% |
$747 |
$8,838 |
$44,838 |
|
10% |
$765 |
$9,894 |
$45,894 |
Data source: Author calculations.
72-month loan
|
Interest Rate |
Monthly Payment |
Total Interest Paid |
Total Paid |
|
4% |
$563 |
$4,552 |
$40,552 |
|
5% |
$580 |
$5,744 |
$41,744 |
|
6% |
$597 |
$6,957 |
$42,957 |
|
7% |
$614 |
$8,191 |
$44,191 |
|
8% |
$631 |
$9,446 |
$45,446 |
|
9% |
$649 |
$10,722 |
$46,722 |
|
10% |
$667 |
$12,019 |
$48,019 |
Data source: Author calculations.
Understand your loan terms
No matter what you're shopping for -- whether it's a home, refrigerator, lawnmower, or new credit card -- interest rates matter. Agreeing to pay a single percentage point more in interest is like allowing the bank to siphon extra money from your account each month.
One surefire way to avoid bad deals is to always ensure you understand the loan repayment terms and to keep an eye on the total cost rather than the monthly one. Another is to get your credit score so high that lenders compete for your business by offering the lowest possible interest rates.
People with very poor credit scores may not get approved for loans at all, whereas those with very good or exceptional scores will qualify for better rates from lenders and more credit card perks or rewards.
Boosting your credit can save you money. There are lots of ways to improve your score, but ultimately it comes down to paying your bills on time and minimizing the amount of debt you carry. And whatever your score, don't forget that you always have the power to walk away from a bad deal.
We're all human. We'll continue to self-diagnose based on the latest Google search results. We'll still touch a plate the second a server warns us it's hot. And we'll still make financial mistakes. What makes us smart humans is correcting those mistakes so that next time, we can get it right.
