INTEREST 101 – Rate vs Cost – Earned vs charged

Interest is always working. It is either working for you or against you. You are either earning interest, paying interest or losing the opportunity to earn interest. There are no other scenarios.

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.

We are taught to focus on interest rates without considering in the least, the cost involved. We are taught to chase high rates of return on our investments and low rates on what we are charged but never to understand the difference in the interest calculations and the dollars involved, which has nothing to do with the rates involved.

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 or loses the opportunity to earn?

We can even take this a step further and draw a second line creating a third column where we add up how much cash we have spent. Then we determine our lost opportunity cost over a lifetime, of spending that money. Cash spent will never be seen again over your lifetime.

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 $471.56 towards principal and $104.17 towards interest. So that means you are actually paying 18.09% interest that month.

After 12 payments you have paid $5,790.24 in principal payments plus $1,118.52 towards interest equals a total of $6,908.76 in payments. The percentage of interest volume you have paid the lender is 19.31% during the first year.

Year 2, 24 months later, you have paid $1,883.81 of interest divided by $11,357.98 of principal = 16.58% interest cost or volume.

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%.

 

click on illustration to enlarge.

Do you think this is why we are taught to focus on interest rates and not the actual  interest cost or volume?

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 higher percentage going towards interest. This increases the interest rate because it is in the last year that the amount of interest you are paying is reduced, because you have already paid for most it during the first three years, which reduces the overall cost of interest. That’s why your friendly salesman wants to give you a deal if you bring your car in before the term is up.

The interest rate does not matter as much as the cost of the interest you are really paying.

Once you pay the lender your money for the car, that money has now gone, never to be seen or used by you again. So now you have to start all over again, borrowing more for the next thing you want.

And if you pay cash, don’t think you are not making payments monthly. You are. You are making payments to a savings account until you have enough money to spend it on the next car. Once you withdraw that money to pay for the car you have lost the lifetime of opportunity that cash could be earning for you, forever.  So you might be saving interest charges but are you? Read here to find out why CASH is not necessarily KING.

What if there was a way to recapture not just the 17% or 10.54% interest charges but also the principal so it was available for you to buy the next car with when you are ready for a new one? Would it be worth it to you to learn how? How many investments offer 10.54 or 17% or even 116% (as you will see below) returns, guaranteed?

Let’s look at another example of rate vs cost

If you are paying for a mortgage, go and have a look at your amortized payment schedule which you should have received when you signed all the paperwork.

Let’s look at a $200,000 mortgage being charged a 6% interest rate over 360 months (30 years). The monthly payment will be $1,199.10.

6% of a $1,199.10 monthly payment = $71.95

However, in real life, in month one, $1,000 goes towards interest and $199.10 goes towards paying back the principal. You are actually paying 83.39% interest volume for your first months payment.

Did you know the national average for Americans either refinancing or selling and re-buying their mortgage/home is 5 years?

At year five, the interest volume is still above 80% at about 80.69%

So for a mortgage that is charging a 6% interest rate, you are really paying over 80%.

It takes 21 years to pay off half the amount you borrowed, $100,000 but you have paid the lender one and a half times the amount you borrowed. Yes, you have paid the lender $302,173 and you still owe $100,000 to them.

Also, if you keep paying the mortgage every month without fail and are charged no late fees or penalties you will pay a total of $431,677 for borrowing the $200,000. That equates to $231,677 of interest volume which is really 116% of what you borrowed.

This is a mortgage loan with a 6% interest rate. So can you see how the cost of a loan is more important to understand than the rate being charged?

Click on illustration to enlarge.

When you refinance after 5 or even 10 years to get points of a percent off your rate, you must consider the fact that you will be;

1. starting your mortgage all over again from month one, lengthening the time you will be in debt,

2. increasing the amount of interest you will be paying by paying the highest percentage of volume, and

3. paying refinance charges on top of that which is really setting you back and sending you further into debt rather than helping you get out of debt, even if your monthly payment is lower.

4. Understand that it will take you at least 5 years to break even with the money you saved by reducing the interest rate. At that time is probably when you will start the process all over again if you are like average America.

Do you know of any investment opportunities where you can earn rates like you are paying on a mortgage? Are you starting to get the picture of why you must understand what you are actually paying in interest charges compared to what you are actually earning as interest income that must be taxed and look at both sides of your financial picture on the same page at the same time?

Where else can you earn 116% or even 80% as a guaranteed return? You see isn’t capturing the interest charges you are now paying someone else, the same as earning 116% or 80% for yourself? Please wrap your mind around that. This must be understood if you want to reverse the flow of your money back towards you instead of away from you. On top of capturing the interest charges you can also capture the principal payments as well. Has a light gone off yet. If not, call me today for further explanation.

Imagine though if you owned the mortgage note?

So we have compared interest rate versus cost. Next we will look at Interest earned versus charged.

Interest Earned vs Interest Charged

Interest is always working. It is either working for you or against you. You are either earning interest, paying interest or losing the opportunity to earn interest. There are no other scenarios.

Money has to move to earn. Stagnant money is money in jail. But for whom is it in jail?

Some examples of stagnant money are Qualified Plans and CD’s.

Some examples of cash flowing and constantly moving are Qualified Plans and CD’s.

What am I talking about? I am talking about the difference between whoever has control of the money makes ALL the difference.

If you are depositing your money into a qualified plan or a CD, aren’t there restrictions and penalties if you touch YOUR money at any point before the term is up? Who set the term? The one who is in control of your money. Why are you discouraged with restrictions and penalties, from moving your money? Is it to protect you, so you don’t spend it all before your retirement, or before the set term? Of course not. It is so they (the ones in control of your money) can keep your money moving for themselves. It is not the owner of the money but the one who has control of moving the money who is making all the profits.

That’s a bit off the topic of interest so let’s get back on track.

Let’s start with Interest Charged

If you look at your monthly statement of any of your loans, it should always show you how much of your monthly payment is paying off your principal debt, and how much is paying the lender as interest.

Right now, I want you to go and get the most current statement of all of your debts, including credit cards, student loans, mortgage, car loans, and any other loans you have that you pay interest on. Go now and get them. Yes, this is a doing blog post not just a reading blog post.

Step 1. – Write down each debts name on the left hand column of a page.

Step 2. – In the next column, write the total amount you originally borrowed for each loan.

Step 3. – In the next column write the total amount you owe now, for each loan.

Step 4 – In the next column write your total monthly payment amount for each loan.

Step 5 – Now write just the amount of each payment that pays off principal debt.

Step 6 – Now write the amount of each payment that pays interest to the bank.

Step 7 – Next is where you will need a calculator unless you are a math wizzz. Here you will divide the interest by the payment to determine the interest volume you are paying right now for each and every loan.

As an example your monthly payment is $1,199.10 of which $1,000 goes to interest and $199.10 to principal. So in your calculator punch in 1000 divided by 1199.10 = and the answer will show as 0.8339588 which translates to 83.396 or 83.4% interest volume.

$1,000 = 83.4% of 1199.10.

Now we want to determine what percentage of your total income is actually going towards paying interest on debt each month, so…

Step 8 – Add up all the amounts of interest listed for each debt for this month.

Step 9 – Figure out what your gross income is. What do you earn before all the deductions of social security, medicare, taxes etc. etc.

Step 10 – Now type into the calculator the total of the interest you pay to all your debts every month, the number from step 8. Then divide this by your gross income total and see what percentage of your income is paying interest to some one else’s bank each and every month.

The national average that people pay in interest payments every month is actually 34.5%. Where do you stand in comparison.

If you are happy working for 8 out of every 12 months to pay for taxes, debt interest and insurance costs then keep doing what you are doing. If you would like to learn about a legal and ethical way to reduce these percentages, call me now. 845-649-7487.

Now We’ll Look at Interest Earned

Following the same type of columns but on a separate piece of paper, write down all the different types of investments you own that you earn interest on. If you sold or withdrew it today, what would that be?

There are different types of earned interest.

We have the simple savings account. How many dollars and/or cents did you earn this month? How much was deposited into your account? And how much money had to be stagnating in your account to earn that amount?

Does your bank pay interest on your lowest monthly balance or on the average daily balance? If you have $10,000 sitting in your savings account for 29 days of a month and then withdraw it so you have maybe $100 left in the account, does the bank pay you interest on the lowest monthly balance of $100 or on the average daily balance where for 29 days you had $10,000 and depending on the month, $100 for 1 or 2 days?

Does your bank add the interest to your account monthly so you earn interest on the interest over the year or does it deposit the interest into your account at the end of the year?

Then there are CD’s (Certificates of Deposit). Average out the amount you earn each month, the dollar amount that is actually added to your account. And once again, how much do you have to have deposited, sitting there, in jail, untouched by you, for you to earn the pittance they pay you? Also, how much penalty do they charge if you have an emergency and need to withdraw your money to cover it?

If you have $10,000 in a CD earning 3% you will earn $300 over the year divided by 12 months = $25 in the first month. If the $25 is deposited into your account that first month, depending on how they figure out the interest, you could earn $25.06 in the second month, because now you are earning interest on $10,025.00. But, if they deposit the interest after the first day of the second month and they figure the interest using minimum monthly balance you will still earn the interest on the $10,000 as that was your lowest balance for that month.

Of course we also have to take into account the fact that we owe taxes on all interest earned. So what tax bracket are you in and how much will you need to deduct from your interest earnings for the taxes?

Mutual Funds

You must figure out how much you have earned on your investments, not by looking at the interest rate or rate of return or what ever but by using the dollar amounts like we did for the car loan and mortgage above.

Also, if your investment is doing really well and you have growth and a profit, that money is not really yours until you take it and deposit it into an account where it is safe because that growth may disappear tomorrow.

Study the diagram below so you see how just taking into account interest rates can be deceiving. If you had $100,000 and a drop in the market meant you lost 36% but then you happily found out that now you had a swing up 83%, (all this taking place over a seven year period) then you would probably feel really good right. But if you switch out the percentages and replace them with actual dollars amounts you realize that you really only had a 1.92% return on your money over seven years. That doesn’t include the mutual fund manager fees you pay whether they are performing well for you or not. And also the taxes on that capital gains and the lost opportunity of what that money could have been doing for you over that seven year period is great. Also, inflation has lowered the value of your dollar over that period of time and so your dollar purchases less than what it did 7 years ago.

Or how about the following example where each investor was told they earned an average 20% rate of return over two years on their  $1,000.

How Are Your Investments Doing?

Now Study the Numbers on BOTH Sides of Your Paper

How many interest dollars are you paying towards interest each and every month?

What percentage of every dollar you earn is flowing towards someone else’s bank?

Now how many interest dollars are you actually earning (after expenses) on your savings and investments each and every month?

NOW, why would you not want to spend some time talking with me about a whole new way of banking?

Why would you not want to have a paradigm shift in your way of understanding how to set up your finances so your money is flowing back into your life instead of away from you and bettering someone else’s life instead?

The financial model most follow needs some changes. If we want to change our countries financial situation, we must start with our own financial situation. You can do something about this. There is the solution. Call me today so I can do a webinar with you and show you so much more and so many more benefits you will be amazed.

I look forward to sharing more with you soon.

 

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June 6, 2011 · Jennifer · 2 Comments
Tags: , , ,  · Posted in: FINANCIAL EDUCATION 101, INTEREST 101 - rate vs cost

2 Responses

  1. David - June 6, 2011

    Fantastic article, Jennifer. You are an awesome teacher! Keep up the good work.

  2. Jennifer - June 8, 2011

    Hi David,
    What a great compliment. I thank you for posting here to let me know. I appreciate your stopping by also. Thanks again.

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