This post was last modified in 2011! We’re digging into the deep history of drafts to bring you things!
Remember when our personal finance Mondays were hardcore personal finance? And not just updates on our own personal finances?
Sometimes it’s hard to visualize what numbers are when the information you are given is in percents, even if you’re good at math. APR and APY aren’t the same thing. Amortization, or how loan repayments are structured can make a big difference on the effects of paying off a loan early.
APR doesn’t take into account compounding. That is, it doesn’t take into account the idea that if you don’t pay off all your interest each month, some of that interest becomes principal and starts accruing interest of its own, compounded monthly. APY does take that into account.
When we’re talking about prepayment for revolving loans like credit cards or cars it gets even more tricky because the interest is generally calculated every month based on how much you owe at that point in time and you’re usually paying some required amount in addition to the prepayment.
Auto loan at 5% APY => each $1000 you prepay at the beginning of the year is $50/year you’re not paying in interest. At 5% APR, that’s going to be a bigger difference. How much bigger? Well, you could put the numbers into the compound interest formula, or you could go online and plug into a debt payoff calculator and just look at the numbers to give you a realistic idea of how much you’ll be saving each month or each year or the life of the loan or how much more quickly you will retire your debt. There are a lot of different calculators out there, each one giving you different inputs and outputs, so you may want to play around with different ones. Here’s one from nerd wallet.
These numbers are different if you’re talking about something structured like a mortgage. They’re amortized differently. For that a spreadsheet is useful. The way mortgages work, the percent doesn’t directly translate with prepayment savings the same way that it does with a credit card or auto loan. Prepayments early on are worth a lot more than prepayments later. This is because when you pre-pay a mortgage, your monthly payment does not change, instead the term of your loan changes. You’re paying your loan off earlier, not changing the amount paid each month. Additionally, you cut more months off with early pre-payments than you do with later pre-payments because pre-payments pay down principal and early in your loan, you’re mostly paying back interest, not principal with your regular payments. With later pre-payments you’ve already paid off most of the interest and your regular payments are mostly attacking principal. In order to truly understand the percent savings from prepayment, it is helpful to use a mortgage amortization calculator or spreadsheet. We like the one from get rich slowly.
Looking at the actual dollar amounts can also tell you that something isn’t worth doing because it saves/makes less money than you initially thought it did. Like that $1K Chase bonus that was really less than $600 when all was said and done, and not worth the hassle of opening and closing accounts and back again.
Has looking at the concrete numbers ever gotten you to change your mind?