Money isn’t magical. It’s a commodity or consumer product like HDTVs and toasters. Lending institutions such as banks, savings and loan associations (S &Ls), and credit unions get their raw material (money) in the form of deposits from millions of people just like you. Then they bundle your cash into neat little packages called loans, which they sell to other folks who use the money to buy cars, college educations, and cottages.
Lenders make their profit on the spread (differential) between what they pay depositors to get money and what they charge borrowers to use the money until the lender is fully repaid.
All loans have the following four basic components:
- Principal: Even though both words are spelled and pronounced the same way, the loan principal we’re referring to isn’t that humorless old coot who ruled your high school with an iron fist. We’re talking about a sum of money owed as a debt: the dollar amount of the loot you borrow to acquire whatever it is that your heart desires.
- Interest: What is mortgage interest? No linguistic confusion here — interest is what lenders charge you to use their product: money. It accumulates over time on the unpaid balance of money you borrowed (the outstanding principal) and is expressed as a percentage called the interest rate. For instance, you may be paying an interest rate of 19.8 percent or more on the unpaid balance of your credit card debt. (Pay off credit card balances as soon as possible!)
Consumer interest for outstanding balances such as credit card debt and a car loan is not deductible on your federal or state income tax return. Interest paid on a home loan, conversely, can be used to reduce your state and federal income tax burdens. There’s a major difference in how you borrow money. Understanding these income tax write-off rules can save you big bucks.
- Term: All good things come to an end sooner or later. A loan’s term is the amount of time you’re given by a lender to repay money you borrow. Generally speaking, small loans have shorter terms than large loans. For instance, your friendly neighborhood credit union may give you only four years to pay back a $20,000 car loan. That very same lender will graciously fund a loan with a 30-year term so you have plenty of time to repay the $200,000 you borrow to buy your dream home.
Lenders allow more time to pay back large loans to make the monthly payments more affordable. For example, you’d spend $568 a month to repay a $100,000 loan with a 5.5 percent interest rate and a 30-year term. The same loan costs $818 a month with a 15-year term. Even though the 15-year loan’s payment is $250 per month higher, you’d pay far less interest on it over the life of the loan:
$818/month ×180 months for a $100,000 loan repayment = $47,240 in interest over 15 years
versus
$568/month × 360 months for a $100,000 loan repayment = $104,480 interest over 30 years
Don’t let a seemingly low monthly payment (with a longer-term loan) fool you into paying a lot more interest over the long haul.
- Amortization: Loan amortization is an ominous word lenders use to describe the tedious process of liquidating a debt by making periodic installment payments throughout the loan’s term. Loans are amortized (repaid) with monthly payments consisting primarily of interest during the early years of the loan term and principal, which the lender uses to reduce the loan’s balance. If your loan is fully amortized, it will be repaid in full by the time you’ve made your final loan payment.