Personal Finance: Defusing Interest Costs

I don't usually dip my toe into this on this site, but it occurs to me most people don't internalize the fact that a lender can't charge you interest on money you don't owe. And that's true of auto loans and mortgages, as well as revolving credit card debt. Most fixed rate loans are front loaded on interest charges, and that gives you a powerful tool to control costs. Let's look at the example below.:

Let's say you take out a 72 month auto loan at 6% for $40,000. (That may seem high, but anyone shopping for a car these days knows prices are really getting out of hand.) This example gives you a monthly payment of $662.

Your interest payments will look like this:

Year 1: $2244

Year 2: $1892

Year 3: $1518

Year 4: $1121

Year 5: $700

Year 6: $252

All in, you've paid over $7700 in interest on top of the price of the car. That's pretty steep. And of course, you're going to pay a price in depreciation on top of that. Looking at it this way, car ownership is probably a lot more of your "wallet share" than you thought.

To use an example with a $30,000 loan, that would be $5800 in total interest with a $498 monthly payment. Still quite a bit of money to add on to the "out the door" sales price. If you added $5800 up front to the price of the car you were buying, you would probably choose a cheaper car. But that is the allure of debt.

But there is a way to defuse the cost of longer term loans likes this if you're opportunistic, and you have some flexibility. By paying principle ahead of time on a regular basis, you can not only shorten the life of the loan by a couple of years, but dramatically slice your total interest costs. And keep for yourself what the lender would have taken from you.

Again, note the example above. By paying ahead early on in the loan cycle, especially in those first two years, you're choking off the ability of the lender to charge you interest expense. Again: they can't charge you interest on money you don't owe, so doing this saves you quite a bit of money. Keep it up, and towards the middle of the loan, you can stop doing it. All you're doing at this point is returning principle back to the lender with little profit to him. Your effective interest rate drops dramatically.

I should add that this subject involves two fairly recent trends: first, far higher interest rates than we're used to, and two, the fact that 60, 72 and 84 month auto loans have become practically normalized. I'm not advocating this, but if people are going to do this sort of thing, they should know they aren't fated to a more costly outcome.

The world of auto finance, unlike mortgage lending, has few constraints, and that's why you hear the "EVERYONE DRIVES!!!" ads on the radio. So hopefully, you're not one of those reckless types who are "upside down" on their car loan the second you drive out of the showroom. When you read about auto loan delinquencies going up, that's not the economy. It's poor decision making.

This also works wonders on 30 year fixed mortgages. If you look at a mortgage amortization table, you'll be shocked to see that the first 10 years are practically "interest only" payments, and you're essentially treading water. In the days when the average home traded hands every 10 years, this was fantastically profitable for the lenders.

So here too, paying ahead of time will save you thousands of dollars. I realize this is a tall order for many homeowners, especially in their first years, when they're finding their feet and homeownership proves to be a lot more than they bargained for. But due to the longer term, taking a disciplined approach to paying down early, even starting in the fifth year of ownership can save the homeowner thousands, and when it's time to sell, they come away with a lot more capital at the closing table. Again, the sooner the better.

This sort of "forced savings" and accelerated amortization is an excellent tool for assuring you'll come out ahead over time. It's delayed gratification, but hey, it's still gratifying. And best of all, it's truly a "riskless transaction."