My buddy took a loan to refinance a credit card with a balooning interest rate. Not having the best of credit (duh) he didn’t get very good terms on the loan. He cut the interest rate by 10%, but not only has his monthly payment gone up, 80% of his payment goes toward interest. At this rate, he’ll pay off the $5,000 in like 8 years.
How is it possible for that much to go into interest? I’m afraid he entered into some crazy deal where even if he has the money to pay off the loan, they’ll want 8 years of interest in addition to the $5,000.
Well you know it’s possible, your friend just did it. It’s probably legal as well, unless your jurisdiction has very strict anti-usury laws.
The amount of each payment which goes to pay off the principal owed is a function of the interest rate and the lifetime of the loan. Generally speaking, Lenders and Borrowers are able to agree on whatever amortisation schedule they like. As the payments continue the interest componenet of each payment will gradually go down, so that your friend’s last payment will probably be something like 96% principal.
In fact you can have loans where the payments during the term of the loan only pay the interest, with the entire principal repayable at the end of the loan (‘interest-only’ loans). Creditors love them because they can the full whack of interest for the entire loan. Borrowers who look only at the monthly repayment think they’re getting a good deal, but if you look a the total amount of interest paid over the lifetime of the loan it’s appalling.
Oh and compare your 80% figure with how much your friends minimum payment was on his last credit card statement comapred to the interest racked up that month - I’m guessing that would be more like 90% of the payment going towards interest.
Wow, that’s bad. And now I feel bad for him. He’s in a bad way financially, and telling him he’s stuck with that monthly payment for the better part of a decade… man.
So it’s entirely possible, that even if he had the $5,000 to repay the loan on him, right now (which I’m tempted to just lend him), they could say that actually he ows them $5,000 + the interest of the loan for the next decade?
He mentioned they said that there would be no penalties if he payed the debt early. That would qualify a s a “penalty” in my book. Did they lie to him?
Whether there’s a break fee or early pre-payment penalty will depend on the contract and your local laws. In a lot of places there are limits as to how much can be charged. So he might** not **need to pay the full interest over the remaining lifetime of the loan if he comes up with the $5,000 tomorrow.
Oh, and if you’ve worked out the repayment time by simply dividing the outstanding principal amount by this instalments payment to principal, you’ve probably over-estimated the time to repay, as the interest component will be chipped away over time. You need to use a loan calculater, (like this for example) and set it to solve for time to get a more accurate figure
If there’s no prepayment penalty , then you only pay the interest due for the amount of time you borrowed the money and paying it off after 4 years will cost less in interest than taking 5 years to pay it off. If you want to pay it off early *, you call the lender and get a “payoff amount” , usually tied to a particular date. Even if there is a prepayment penalty, it’s usually a percentage of the loan amount or some number of months worth of interest, not the amount of interest you would pay if you tool the full term of hte loan to pay it off.
for at least some loans, you need to get a payoff amount for the last payment, even if you’re not paying it off early
So I’ll tell my friend to get a payoff quote, right? Hope he gets a reasonable number back, like under the $5000 he actually borrowed (since he’s made a few payments already).
It’ll only be worth getting a quote if he’s got the money. And it may be over $5,000 if he’s made less than 4 payments or there is some sort of fixed prepayment penalty (eg ‘amount outstanding plus 6 months interest’ or ‘amount outstanding plus an early payment processing fee of 5%’).
Sounds like the “Rule of 78’s” (AKA “Sum of Digits”) interest calculation, or something very similar. This is where the payment stays the same over the life of the loan, but interest payments are front loaded. For these type loans 12/78’s of the total interest due would be billed on the first payment. The tiny remainder of the payment would got to principal. The next month 10/78’s of the interest would be due, then 9/78, etc. The 12th payment equals 1/78th of the total interest, the remainder of the payment would be applied to principal. In these loans, by the 6th payment you will have paid almost 3/4 of the total interest due. The vast majority of principal is paid back during the last half of the term. So if you went to pay a one year loan off after 6 payments, you would find that you still owed far more than half the principal.
I can’t say that’s what it is for sure because the Rule of 78’s is no longer legal in the US for loans terms greater than 5 years and some states have outlawed them almost entirely.
With loans like this, that have the same payment amount every month (most mortgages are this way), at the beginning almost all the payment goes to interest, and at the end almost all the payment goes to the principal. That’s just the way it works, if you want to pay the same amount every month, and the amount of interest each month is based on how much principal is left. If you think about it it makes sense-- all of the principal is still there at the beginning so there’s a big chunk of interest, and there’s not much of the payment left to pay off the principal. At the other end, the timing and payment amount have been arranged so the last payment is going to pay off the very last bit of the principal and so there won’t be any interest. This is completely legal, and as I said, the way nearly all mortgages are arranged.
So your buddy’s not getting screwed over any more than anyone with a mortgage.
To address the other question, of course the lender can’t suddenly demand anything more at the end of the loan; him and the lender have already agreed what he’ll pay. lisiate was just saying that there are other kinds of agreements for loans; but again that’s not the kind of loan your friend has.
Damn those are some insane loan terms. A $500 loan fee for a one year $1,000 loan? Who goes for that kind of deal? You’d save up that much in five months if you just put aside the monthly payment for that long.
Re the Rule of 78s, I’m pretty surte that was an approximation back in the pre computer age when calculating interest on a daily basis and the like was a tedious chore. Interest payments are still front loaded in most cases, as Quercus points out. The only difference now is that we don’t resort to a rough approximation to figure out how much of each payment goes to interest and how much to principal.
If he can find some way to pay more than the minimum each month, he’ll end up paying a lot less over the life of the loan.
I highly recommend www.mint.com for helping him figure out just how much he’ll save in what would have been interest payments, and to help make a plan to melt away his death. Warning: they do try to hock things all the time at you, but it’s a free service and very helpful with managing debt and planning savings and whatnot.
Disclosure: I am not a Mint employee or in any way affiliated with them other than as a user
In the rule-of-76 computation for monthly payment of P & I, interest is advanced early on to realize the income much sooner. Towards the end, the borrower pays mostly principal.
BTW, while it isn’t as efficient or as accurate as some of the calculators mentioned, you can set up a simple spreadsheet to show him the amount of principal and interest paid each month. it is illuminating.
Only if those excess payments are applied to principal!
That is where the Rule of 78’s method originated, but it is still out there on some short term, small loans. Computers didn’t eliminate greed, they just give lenders more ways to be greedy~:D
If the OP is talking about a 5,000 loan for 8 years, that means the interest rate is about 18% and the payment amount is about 100 per month. Is that about right? Using my numbers, interest is 75% of the payment in month 1, 50% in month 48, and almost zero for the last payment. That’s a normal progression for any loan.
In undergrad for mechanical engineering, I was required to take a course called “engineering economics.” Not sure why they gave it such a grandiose title, because it seemed to focus entirely on the time value of money, the utility of which extends far beyond engineering. The course turned out to be a blessing for me in my personal life, because now I know how to calculate payments on a loan, returns on investments, retirement planning, and so on; it’s been invaluable in making decisions about buying a house, refinancing, taking out a loan for a car, and so on. I don’t particularly remember the equations off the top of my head, but I know that those equations exist and can look them up, or else just use the built in functions in Excel (look up the financial functions; PMT() is the important one for loans).
As you’ve suggested, a spreadsheet that maps out the entire series of payments for the life of the loan is a useful tool for understanding where your money is going, and is a valuable adjunct to a personal budget. If you’re smart about how you set up the spreadsheet, you can show the declining amount of principle that remains after each payment, and calculate the interest portion of each payment (based on the interest rate, the amount of principal remaining, and the length of time since the last payment); it shows very clearly how much of each payment is interest, and how much the sum-total of interest is over the life of the loan. For high interest rates and long payback periods, the interest paid can vastly exceed the principal.
For my mortgage the first payments were about 80% interest.
If he can’t pay off the entire loan at once he should try and pay as much additional principal as possible. Even a few dollars a month will make a big impact.
