Save money by minimizing loan interest

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My sister-in-law recently discovered that the mortgage payment she and her husband make each month does not reduce their mortgage debt one iota. Their mortgage payments are applied exclusively to the interest payments on the loan and the loan balance is not reduced.

Fixed rate mortgages are when the interest rate remains constant for the life of the loan. Some mortgages are variable rate, meaning the interest rate will fluctuate based on the future cost of borrowing. Balloon rate mortgages mean that your rate is fixed until a certain date, then it skyrockets. Too many people only care about their rate now and don’t worry about the rates they might be contractually obligated to pay later.

Some mortgage lenders allow you to pay off your loan balance. It is simply a matter of making an additional payment and assigning it specifically to the loan balance. It’s best to accompany it by writing “reduce loan balance” in the subject section of your check and accompanying it with a note stating your intention. And then follow up to make sure your instructions were executed.

Paying off your loan balance results in your interest rate being applied to a smaller principal later, which means less money is paid in interest over the life of the loan.

However, some mortgages are written in language that prohibits you from paying off your balance until all of your interest is paid off. This is to the benefit of the lender as it ensures that the maximum amount of interest will be paid on your loan.

On a smaller scale, the same system applies to car loans.

Many dealerships make more money from the interest you pay them on a car loan than from selling you the car in the first place. That’s why dealerships go to great lengths to ensure that you take out your car loan from them, not from a third party. They will tell you that they offer the best possible rates; sometimes it’s true, sometimes not.

I first bought a new car in 1996. I deliberately chose a Saturn dealership because Saturn treated all customers the same. There was no hesitation or negotiation. Every car had a unique price, every optional feature had a unique price, and no matter how much you knew about cars, that was the price you would pay.

After a salesman and I picked out a car, I was directed to another office where the guy in charge of the paperwork sat. He explained the buying process until we got to the point where we had to decide on a monthly payment schedule for the car.

“How much do you want to pay? ” He asked.

I thought for a moment, then replied, “What are the options?”

I asked him a pretty simple question, I thought, but he did a double take and leaned back.

“You know,” he said, “it’s the first time anyone’s asked me that.”

I asked, “How do other people react when you ask them how much they would like to pay?”

He told me that they all told him that they wanted to pay “as little as possible” each month.

But paying as little as possible per month means it will take you several more months (maybe years) to pay off the car. This will extend the term of the loan and significantly increase the amount of interest you end up paying over the life of the loan.

I chose a four year plan, but paid it off in three years. The plan allowed me to make additional payments as often as I wanted, and in doing so, I could repay the loan earlier than contractually scheduled and thus reduce the total amount of interest paid on the loan.

Not all car loans allow you to do this. After all, the lender wants as much of your money as possible, which they maximize by charging you as little as possible each month.

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