Here are some borrowing fundamentals:
- Borrowing costs you money because interest and fees are added onto what you borrow.
- Because interest and fees are added onto what you owe, the more you borrow, the more it will cost you to pay back.
For example, if you borrow $100,000 with a 5% interest rate, your yearly interest will be $5,000. If you borrow $50,000 with the same 5% interest rate, your yearly interest will be $2,500. That’s a difference of $2,500. (In this example, we changed the amount borrowed, but the interest rate stayed the same.)
- The Interest Rate Charged on Your Debt Really Matters.
For example, with a 1% interest rate on a $10,000 debt, you will pay $100 in interest if you pay the $10,000 back within a year. If you increase the interest rate to 10% on the same $10,000 debt, you will pay $1,000 in interest if you pay back the $10,000 within a year. That’s a $900 difference due to the interest rate in just one year.
On larger debts that take a long time to pay off, differences in interest rate have a much greater impact, costing or saving you a lot of money depending on the higher or lower rate. Let’s say you borrowed $23,000 in student loans with a 5% interest rate. If you take 25 years to pay it back, it will cost you $40,338. That’s a lot of money, but it can get much worse with a higher interest rate. For example, if you increase the interest rate in the example from 5% to 12% and keep everything else the same ($23,000 borrowed and 25 years to pay back), it will cost you $72,672!
That’s why it’s very important to know your interest rate and know if it’s fixed (stays the same) or if it’s adjustable/variable (meaning it can go up or down). If your loan starts off at 5%, then increases to 12%, you might not be able to afford it.
- The longer you take to pay back a loan, the more it will cost you.
This is because you will be charged interest and fees over a longer period of time. Let’s take our student loan example from number 3 above. Let’s say you got the fixed (stays the same) 5% interest rate because you got a government-backed Federal Stafford Loan (as opposed to a private student loan, which usually comes with higher interest rates and fees) and you borrowed $23,000. If you chose the 25 year repayment plan, it will cost you $40,338.
However, if you chose the 5 year repayment plan and everything else stays the same ($23,000 borrowed at a 5% interest rate), the amount it will cost you decreases to $26,042, a savings of $14,296. That’s $14,296 you can use on something else other than just paying off debt.
- Don’t get fooled by low monthly payments.
Some loan specialists or car sales people will try to get you to focus on the monthly payment. As our chart shows below, that is only part of the full picture.
Let’s keep rolling with our student loan example of borrowing $23,000 with a 5% interest rate.
Monthly payment Loan Duration TOTAL payment Saves $134.46 25 years (300 payments) $40,338 X $243.95 10 years (120 payments) $29,274 $11,064 $434.04 5 years (60 payments) $26,042 $14,296
Please note that with the lower monthly payments, the loan takes longer and costs much more to pay off. If you are only looking at the monthly payment, the $134.46 seems like the best deal, but it will take you 25 years to pay off the loan and cost you $40,338. Compare that to the $434.04 monthly payment plan that will pay off the loan in five years and cost you $26,042, a savings of $14,296.
Granted, the monthly payment amount is part of the picture, as you need to be able to fit it in your monthly budget, but don’t forget about other important considerations such as the total payment of the loan, how long it will take to pay off, the interest rate, whether the interest rate is fixed, and the amount of fees you will be charged with the loan. If the only way you can afford something is to pay a huge amount of interest to get a smaller monthly payment, perhaps you can’t really afford it at all.
- Be aware of fees.
Fees are additional charges and are added into the amount you owe. They can be charged for services such as loan origination (or, in simple terms, offering the loan) or penalties such as late payment fees.
You should be aware of the fees you are being charged and what triggers penalty fees (such as late payments or borrowing more than your credit limit).
The pinnacle of debt awareness is understanding the concept of the “thin red line.” The ultimate goal is to get above the line and build wealth. Any decision that creates debt must be examined carefully. Taking on a debt is a risk, and knowing the borrowing fundamentals and being aware of the thin red line and other money management mindsets will help you make an informed decision that minimizes the risk.