Interest is the cost of borrowing money from a lender. When consumers borrow money, they get charged an interest rate (%). This is how the lender makes their money. The higher the rate, the more money you are paying that lender to borrow you money.
Your credit score and type of credit you are trying to attain will determine your interest rate. A credit card, for example, can have an extremely high rate (25%+), while a home loan can be as low as 3.5%. That’s a HUGE difference! Also, it’s very important to maintain a high credit score. Having good credit will save you a lot of money in interest costs, making your purchases cheaper in the long run!
This Is Why It’s Very Important To Try To Get The Lowest Interest Rate Possible
Too many people just look at the monthly payment and not the rate being charged when talking with a loan officer. If you are unaware what interest really is and get charged a high rate, you can waste a lot of money and end up paying way too much for your purchase.
How Interest Effects Your Monthly Loan Payments
When you make a monthly payment on your loans, a portion of your payment is going to pay off the balance you owe (also called the principle) while another portion is going to pay interest. Most people don’t realize how much they are spending on interest fees every month. Look at your loan statements, they should clearly show you how much of your monthly payment is going to interest and how much is going to the principal.
When you initially start making loan payments, you are paying more on interest cost at the beginning of the loan term than at the end. This is because when you first take out a loan, you owe the most money back to the lender and have the highest balance. As you continue to make monthly payments, your principle balance gets lower and lower, causing your interest payments to decrease in the same manner. By the end of your loan term, you will notice your loan balance dropping even faster because most of your payments are going to the remaining principle and not as much is going to interest.
The Cost Of Buying A New Car With Good, Mediocre, and Bad Credit
Let’s pretend you and two friends all buy the same car for $20,000 and you each take a loan out for the whole amount ($20k). Each of you has a different credit history so each of you get a different credit score – leading to different interest rates when taking out the car loan.
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Good Credit History
In the first example below, you have a good credit score because you read InvestMoneyRight.com 😉 and you get a loan with a 3% rate. Nice Job! You end up spending a total of $1,562.46 on interest over 5 years. This is the cost of borrowing $20,000 for 5 years making your total purchase cost $21,562.46 (not including fuel, insurance, fees, etc.). Here is the breakdown of how the total monthly loan payments accumulate yearly. (You’ll notice the higher interest payments in the beginning of the loan compared to the end of it) –
| Loan Amount | $ | |
| Loan Term | years | |
| Interest Rate (APR) | % |
| YR | Beginning Balance | Interest | Principal | Ending Balance |
| 1 | $20,000.00 | $548.53 | $3,763.91 | $16,236.04 |
| 2 | $16,236.04 | $434.04 | $3,878.40 | $12,357.60 |
| 3 | $12,357.60 | $316.08 | $3,996.36 | $8,361.18 |
| 4 | $8,361.18 | $194.53 | $4,117.91 | $4,243.22 |
| 5 | $4,243.22 | $69.28 | $4,243.16 | $0.00 |
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Mediocre Credit History
In the second example, your friend’s credit isn’t as high as your is, so she gets a 6% rate on her loan. She ends up paying $3,199.37 in interest over 5 years making her total purchase cost $23,199.37 for the car –
| Loan Amount | $ | |
| Loan Term | years | |
| Interest Rate (APR) | % |
| YR | Beginning Balance | Interest | Principal | Ending Balance |
| 1 | $20,000.00 | $1,103.81 | $3,536.11 | $16,463.94 |
| 2 | $16,463.94 | $885.72 | $3,754.20 | $12,709.78 |
| 3 | $12,709.78 | $654.17 | $3,985.75 | $8,724.07 |
| 4 | $8,724.07 | $408.34 | $4,231.58 | $4,492.53 |
| 5 | $4,492.53 | $147.33 | $4,492.59 | $0.00 |
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Bad Credit History
The last example, your friend has bad credit and gets a 12% rate on his car loan. He ends up paying a total of $6,693.30 in interest making his total purchase cost $26,693.30 – for the exact same car everyone else bought!
| Loan Amount | $ | |
| Loan Term | years | |
| Interest Rate (APR) | % |
| YR | Beginning Balance | Interest | Principal | Ending Balance |
| 1 | $20,000.00 | $2,232.86 | $3,105.82 | $16,894.20 |
| 2 | $16,894.20 | $1,838.98 | $3,499.70 | $13,394.50 |
| 3 | $13,394.50 | $1,395.10 | $3,943.58 | $9,450.95 |
| 4 | $9,450.95 | $894.97 | $4,443.71 | $5,007.26 |
| 5 | $5,007.26 | $331.39 | $5,007.29 | $0.00 |
Why Would You Want To Spend More Money On The Same Car?
These comparisons show why it’s very important to understand how interest can impact your purchases. For the exact same $20,000 car, three friends paid completely different prices for the vehicle. By having a good credit score and not messing around with risky debt, you can reduce your interest expense and contribute more to building your wealth!
