Loan Interest Insight

The past two weeks have been destructive. Between programming, tutoring, and everything else, I haven’t been able to keep up very well. Not good news for a Real Estate Principles course that’s only four weeks long. This week I have to take the midterm, finish the rest of the book, and take the final by next weekend.

While studying some math problems I made an amazing discovery: You pay interest first. Always.

Say you take a loan for 100,000 at 10 percent. That means every year you have to pay 10,000 in interest. 10,000 divided by 12 is 833.33 bucks a month. That means if you pay 1,500 a month, only 666.66 will go toward the principal (the amount you money you borrowed). That means that over half of the money you spend will pay for the interest, not the money you actually owe!

Why does this matter? Because the amount you owe is the you pay the interest on. So if say for a few months you pay 833.33, guess how much of you’ve paid back? Nothing. You could pay 833.33 forever. The first 833.33 just goes to pay for the fact that you’re borrowing that money. Only after you pay down your principle does your rate go down.

Now most homes in California, at least in the Bay Area, cost a lot more than 100,000 so that means that unless people are paying several thousand each month, they’re not making any progress and are actually accumulating debt.

The only offset to this is the values of the properties keep growing. So if the property value grows faster than the 10% and they can transfer or close the loan when they sell the house, then they can actually make money while technically in debt. This kind of borrowed money, used to invest, is called leverage. Some people make a living off this. They take loans, invest, and the investment grows faster than the interest on the loan. The only problem is what happens on a failed investment.

What’s crazy about this example is how fast interest can compound. If someone has a loan for 100,000 at 10 percent, and they pay 1,500 a month, they would end up paying for 9 years, and end up paying over 50,000 on interest.

Now take a house at 500,000 at 10 percent interest. Paying off the loan at 1,500 a month, a person would accumulate 3,200 bucks in additional debt the first year, and 35,200 the second, and this amount would only grow. Crazy huh. The person would have to pay 4,700 a month just not to gain any debt.

Big numbers, huh. Now bank rates actually make a really big difference. If say that 100,000 was under a rate of 8 percent. Only a two percent difference. That means the person would end up paying their loan off a year earlier and would pay 15k less on interest.

Similarly, paying more makes a huge difference too. Say instead of paying 1,500, someone paid 1,750. Not a huge difference, but lets just see the impact, at both 8 and 10 percents. At 8 percent, those extra 250 a month would save an additional 6k and pay the loan off a year faster. For the 10 percent loan, those extra 250 would let a person pay off the loan in seven years and save over 10k on interest too.

This really makes you think not only about money owed but money you get paid interest on. If you have money in a savings account getting a whopping two percent interest a year, imagine the difference in how much one could accumulate if they put it into a CD at four percent, or better yet invested in something that could give seven or eight.