INTEREST, rate vs cost – earned vs charged
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Financial Strategies # 5 INTEREST rate vs cost – earned vs charged
By Jennifer Bhala
As a society we have been trained to look at certain aspects of banking in a limited way because by so doing we can easily be manipulated into thinking something we are offered is a good thing for us, when in fact it isn’t.
There are multiple market myths and half truths that have distorted what people believe is helping them financially when in fact it is hurting them. Basically we have been taught to do what the banks want us to do and think the way they want us to think.
How many people do you know who actually draw a line down the centre of a piece of paper and on one side write down the actual amount of interest in dollars they have earned over say a year and on the other side of the same piece of paper write down the dollar amount they are paying in interest charges? I hope you understand that I am not talking about interest rates and rates of return, I am talking about the actual amount of interest in dollars that one either earns or pays?
Rate versus Cost
There are multiple ways of calculating interest. I don’t know them all, but some are compound, simple, average daily balance, amortized, minimum monthly balance, to name a few.
The way interest is calculated makes a huge difference to the actual costs associated with a loan. For instance when you purchase a car for example
the interest rate might be 5%,
cost of car $25,000,
monthly payment $575,73,
with a 48 month term.
So what is 5% of a monthly payment $575.73? answer is $28.79. Most people think this is what they are paying.
However the first payment will be divided into $471.57 towards principal and $104.17 towards interest. So that means you are actually paying 18.09% interest that month.
After 13 payments you have paid $25,000 – $18,714.02 = $6,285.98 in principal payments plus $1,198.54 towards interest equals a total of $7,474.52 in payments. The percentage of interest volume you have paid the lender is still 16.01%.
So for the first 13 of 48 months you are really paying an average of 17% interest on a 5% loan.
If you do pay the whole loan back over 4 years you will actually pay $2,635.15 in interest charges which is 10.54% of $25,000 on a loan charge rate of 5%.
The national average is that most people return their vehicle for a trade in before they have paid off their loan, so during the last year or two when you would be paying mostly principal payments you start a new loan all over again beginning with the high
