Who wants to buy one car for the price of two? All you have to do is get a loan for six years at a 12% interest rate, and pay it off as scheduled. Gross, isn’t it?
Actually it’s compound interest. It’s bullish if you’re getting it, but a real beast if you’re the one paying it. Most people know about the magic of compounding investments, but it works the other way too. And just as some rates are better for investments than others, debts should also be avoided with certain interest rates, unless you enjoy doubling your debt.
Time isn’t the only factor, but it’s the biggest. The Rule of 72 is Einstein’s simple shortcut to figure out how long it takes for an interest-compounded value to double. It’s not exact, but it’s never more than half a year off. Just divide 72 by your interest rate, and there you have how long it would take for the loan or investment amount to double.
So 1% would take 72 years to double. 5% takes about 15 years to double. 10% takes 7.2 years to double. 20% takes 3.6 years to double, and 36% doubles in just two years. So if your loan duration is long, as in home loans, keep in mind it takes even less time for it to re-double (or quadruple). And it’s usually redoubling about half a year quicker for most good-credit rates.
As in the example above, if you’re buying a car with a loan (which is typically never more than six years), you want to stay under 12% interest to avoid paying double. And 12% is a magic number too, being the first to quadruple in almost two years less time than it took to originally double. Therefore, as soon as your interest rate is 12% or higher, your debt is growing at the fastest rate possible.
Bad credit isn’t entirely hopeless though. If you find yourself stuck in a position where you cannot get a good rate, you should then shop around for a loan that welcomes early payment. It’s more than avoiding early-payment penalties though. The loan should also get recalculated every time you make a payment on the date you made the payment regardless of due dates.
In other words, you can avoid doubling your debt if you can pay more often. Obviously paying more than your obligation helps too, but you can effectively cut up to 10 points off your rate just by dividing your monthly obligation into at least bi-weekly, if not weekly, payments. So if you have a $400 monthly obligation, paying $100 every week cuts back on the interest accrual, saving thousands over the course of the loan.
However, that only works if your loan doesn’t have a static monthly payment term. Talk to the underwriter or loan advisor about the terms of your loan. They will be able to tell you whether it is amortized on payment or on a specific date regardless of when you paid.
By the way, if you can’t get a used car loan under 12%, you should buy new. Legally, new car loans can’t exceed 8%, and you can still get an early-payment loan on that too.
Visit TheDollarStretcher.com today for 10 things you need to know about compound interest and what you need to know before you shop for an auto loan.
This article by Patricia Mayo first appeared on The Dollar Stretcher and was distributed by the Personal Finance Syndication Network.
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I learned much about the rule of 72. As expected, I am planning to pay off my debt more often to avoid further increased rate of interest.