The last installment in our recent series about using debt wisely is to talk about another key difference you’ll see among types of loans: the interest rate. There are two main types of interest rates you may run into on loans: fixed and variable.
A variable interest rate (sometimes called an “adjustable” or a “floating” rate) is an interest rate on a loan or security that fluctuates over time because it is based on an underlying benchmark interest rate or index that changes periodically. A fixed interest rate is an unchanging rate charged on a liability, such as a loan or mortgage. It might apply during the entire term of the loan or for just part of the term, but it remains the same throughout a set period. Considering whether a rate is variable or fixed and for how long can help make the decision of what to pay off or consolidate first.
Let’s look at another example. This time we’ll look at Sam’s cousin Sally.
Sally has the following bills:
Credit card - balance of $10k and monthly payment $150 interest 19% variable
Car loan - balance $20k and payment $450 interest 3% fixed 5 years left
Private loan - $30k and payment $150 interest 8% fixed 10 years
Sally makes $4,000 per month working as an actor.
Sally does not own a home and pays $600/month in rent, her monthly bills are $1,350.
All figured, Sally thinks she could afford to put an extra $350 per month toward paying off her debts.
Sally wants to make her situation better but lacks a house to use secure debt to consolidate so she’ll have to come up with a payment strategy.
The first bill she’ll want to pay off is the credit card, because it is a high rate and it’s variable so the rate could even go up. Once that is paid off, Sally can then use the $150 per month she was paying on the credit card along with her original $350 to attack the next bill.
But, how will she choose between the car loan and private loan? One has a higher monthly payment she could get rid of, but the other has higher interest.
One way to figure this out is look at how much interest is left to be paid on the other two loans. We can do this with some simple math:
Car loan: $20,000 * 3%= 600 annual, so multiply it by the term 600*5=$3,000
Private Loan: $30,000* 8%= 2400 annual so multiple it by the term 2400*10= $24,000
Looking at the loans this way we can see that there is much more potential savings in paying off the Private loan than if we pay off the car. Paying off the private loan with the extra $500 per month we now have will save us about $12000 in interest, whereas paying off the car loan first would have only saved us $600 on that loan. It would have been very tempting to pay off the car first because it had a lower balance and higher payment, but this would have hurt Sally long term.
Looking at your debt from multiple angles and will help you make the right decisions to put yourself in the best financial situation. Always consider the specifics of your finances instead of relying on generalities to make decisions.