Are you ready to be shocked? Then gather your most recent statement for each loan you have and walk through a short exercise with me. Somewhere on the loan will be a breakdown of how much you borrowed, the amount of your monthly payment, how much of your monthly payment goes toward the principal, and how much interest you are paying on your loan. With this information in hand I want you to make a 4-column chart to record your data (you can use a spreadsheet or paper and pencil; both work great for this exercise).
How much interest are you paying?
It’s one thing to know the interest rate you are paying on your loan, but it takes on an entirely different meaning when you see how much money you are actually paying toward interest each month. In many cases, the final number is shocking! I created an example debt chart to represent loans that a young couple may face shortly after starting their life together. Details about the hypothetical loans follow the chart.
Example debt chart:
|Auto Loan 1||$368||$312||$56|
|Auto Loan 2||$250||$215||$35|
|Credit Card 1||$150||$25||$125|
|Credit Card 2||$150||$42||$108|
Almost HALF the loan payments are for interest!
When you look at the numbers it almost doesn’t seem real, but it is – 46% of these payments go straight to the lender in the form of interest. It is amazing to see how much interest is charged on loans, and many people don’t realize how much interest they are paying until they write it down. These numbers are even more difficult to swallow when you realize they are monthly numbers and the annual interest would run over $13,000, which is a substantial percentage of many people’s take home pay.
Of course, each situation is different. For example, the mortgage interest makes up the vast majority of the interest in this chart, but even if you remove it, you would be paying $392 interest on $1477, or roughly 27%.
Hypothetical, but realistic numbers. The loans in this example represent common loans that many young couples face shortly after graduating college, getting married, and starting a family. The numbers used in this example were arrived at by using an amortization schedule calculator for reasonable loans at various stages of repayment to simulate a real world situation.
Loans and interest rates used in this example:
- Mortgage – 30 years, $150,000 loan @ 6.0% interest after 5 years. Mortgage payment does not include property taxes, insurance or PMI.
- HELOC – $20,000 @ 5.0% for 5 years after 3 years.
- Student Loans – $20,000 @ 2.0% for 10 years, after 5 years.
- Auto Loan 1 - $20,000 @ 4.0% for 60 months; after 1 year.
- Auto loan 2 – $15,000 loan @ 6.0% interest for 48 months; after 2 years.
- Credit card 1 – $7,500 @ 20% interest, paying $150 each month with no new charges.
- Credit Card 2 – $5,000 @ 10% interest, paying $150 each month with no new charges.
How long will it take to pay off your credit card? The example in this article uses a credit card with a $7,500 balance at 20% interest. If you pay $150 per month and don’t make any new charges, it will take you 108 months to pay off your card. That is 9 years! The second credit card bill will take 40 months to repay.
How to reduce the amount of interest you pay
As you can see, paying interest will get you nowhere fast. There are several ways you can reduce the amount of interest you pay each month – and you have already done the first step, which is recognizing how much you are paying. The next step is to stop adding new debt, which means no more credit cards or additional loans.
Following that, you will want to try and negotiate lower interest rates. You may not be able to do that for fixed rate loans without refinancing the loan (which may cost money or be subjected to other conditions). But you may be able to negotiate lower interest rates on your credit cards or other non-fixed rate loans.
Other options include creating your own do it yourself debt consolidation plan, which may include using a 0% balance transfer credit card to consolidate you credit card debt at 0%, using your HELOC to consolidate your higher interest loans, or consolidating your loans through a peer to peer lending company such as Lending Club or Prosper. These loans allow borrowers to take an unsecured loan to use as they wish. In this case, consolidating debt may be a good way to pay less interest and simplify the repayment process by making fewer payments.
The importance of paying more than the minimum payment
As you can see by this example, paying the minimum on your loans means you are sending a lot of money to the lender each month instead of reducing the principal you are paying. When you make extra payments that money goes straight to the principal, which reduces the amount of money you owe, the interest you owe, and the time it will take to pay off your loan. It’s a win-win situation for you.