Different Strokes for Different Folks
Also, there are different interest rates for different kinds of loans.
Mortgages are probably the biggest loans most people ever get. Mortgage interest rates are the lowest because the bank gets the house if the payments aren’t made. That is, the house itself is used as collateral. And most banks require the buyer to put, say, “25% down”… meaning that if the buyer is buying a home for $300,000, she must put 25% of $300,000 or $75,000 down on the house BEFORE she’ll get a mortgage for the remaining $225,000. That way, if they house goes down in value 15%, AND the bank has to spend $10,000 in legal fees kicking her out of the house and then another 5% on a realtor to sell the home and $5,000 in taxes and other fees to keep the house “alive” during the liquidation… the bank still gets its principal back (and in theory the interest as well).
• Home: $300,000
• Loan: $225,000
• Home declines 15% or $45,000 and is now worth $255,000 on the market.
• Realtor fees to sell: $12,500
• Legal fees to take possession: $10,000
• Operating fees: $5,000
• That $255,000 then has a further $27,5000 in value reduces from it to net:
The bank juuuuuust gets its money back then on the loan it wrote for $225,000 and the extra little bit covers some, likely not all, interest payments.
Car loans are installment loans. You borrow enough to pay for the car, and then pay the loan back over time in fixed payments (installments). Interest rates on those are around 6% these days. And the bank gets the car if the payments aren’t made.
In case you skipped the first part of this article or wondered why Visa which is publicly traded is worth billions and billions of dollars, credit cards are the most expensive way to borrow money--they have the highest interest rate. There’s nothing for the bank to “get” if you don’t pay back this kind of loan, so the bank charges more to loan money this way.
Thrifty Tom and Saver Sue just bought their first house—a bungalow full of neat old glass and nooks for their computers. It’s close to downtown where Saver Sue works. At $159,900, they got a great deal on it, but it’s definitely a fixer-upper. The first thing they want to do is add a bathroom because one of the first rules for a happy marriage is “Don’t share a bathroom.” There are some things they need to fix, too. Like getting a new furnace and a new roof. Anyway, their contractor gives them a total price of $17,000 and is all ready to start. Now they have to decide how to pay for it all…now, because they don’t want to swelter without A/C or freeze without heat while they save up enough money. Plus, they would need more buckets to put under all the drips from the roof.
Since they have okay credit, they can get a credit card rate of 18% or they can jump through hoops to apply to their bank for a 2nd mortgage that they could probably get at 7%. A 2nd mortgage is the loan people get from the bank to do stuff to their house where their house is collateral (collateral is an actual thing of value that backs up a promise to pay), so the interest rate isn’t as high as a credit card.
|Credit Card||2nd Mortgage|
|Thrifty Tom and Saver Sue borrow this much||$17,000||$17,000|
|The payment they can afford to make each month||$500||$500|
|How many payments it will take to pay it back||48 months||39 months|
|Total interest they'll pay||$6,957||$2,003|
Looking at their options, it’s really a no-brainer since they do not want to pay triple the total interest by financing the improvements to their new home with a credit card. They decide to go ahead with the dog-and-pony show of the 2nd mortgage application process.