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Having debt is one of the universal aspects of living in the United States. Debt is typical for Americans regardless of age, ethnicity, income, or education. According to the Federal Reserve, American debt set a new record in the spring of 2021. Roughly 340 million people had a total of $14.6 trillion in debt. That’s an average of nearly $43,000 per person. Debt includes credit card debt, home mortgages, student loans, etc.
The key to managing debt is a clear path out of it. It’s virtually guaranteed that you’ll need to go into debt to pay for a new house or higher education. The trick is understanding your payments and how long you’ll have to make them.
How do loan payments work?
You’ll be paying three different costs that come with taking out a loan:
- The principle is the money you initially received when your application was accepted.
- The interest is a percentage of the principal that will change based on your credit score and credit history.
- Any additional fees can be tacked on, such as origination, late, or early payment fees.
These factors (except fees) are considered while your loan is being reviewed. As a result, you should know how much your monthly payments will be before you ever sign anything.
Repaying a loan isn’t as simple as paying back the money that you were given. If that were the case, no one would want to be a loan lender.
How can you calculate monthly payments?
You should have a general idea of your expected monthly payment before applying for a loan. Most loans require a hard credit check which can affect your credit. The last thing that you want to do is damage your credit just to realize that you can’t possibly afford to repay your loan.
There is quite a bit of math involved in calculating your potential monthly payments. Most loans are amortizing, meaning your monthly payments will be used to cover the principal and the interest each month. Although the monthly payment will remain the same, the interest you pay on the loan will decrease with each payment.
To calculate the portion of the monthly payment going to principle, you just need to divide your interest rate by the number of payments you’ll make and apply this number to your principal balance.
The amortization schedule and the formula for an amortized loan are very complex, so it’s best to use an example:
Let’s say you buy a new car for $18,000 with an annual percentage rate (APR) of 5%, a five-year repayment plan, and no additional fees.
- You’ll first divide the interest rate (0.05) by the number of payments you’ll make each year (12) to get 0.00416.
- Next, you’ll multiply this number (0.00416) by the initial balance of your loan (18,000) to get 75.
- The 75 would represent $75 in interest for the first month. As you continue to pay the loan, you’ll pay less in interest and more in principal.
- When you get the loan terms, the company will often tell you how much your minimum monthly payment is — some loans do a percentage of the principal, while many others divide the principal amount by the number of payments left.
Based on the above example, each monthly payment may fall around $300. The first payment would be $75 in interest, with $225 going to the principal. The interest rates would continue to decrease with each payment. By the 60th and final payment, you would only be paying just over a dollar in interest, with the remainder of the payment paying off that principal balance.
What are the most common types of loans?
The basic concept of a loan is that you borrow money upfront and slowly repay it over time. While that sounds simple enough, there are a lot of differences between loan types.
Here are a few of the most common types of loans and how they typically function:
- Personal Loans
- Student Loans
- Auto Loans
- Mortgage Loans
- Debt Consolidation Loans
- Home Equity Loans
A personal loan is one of the most flexible types as the money can usually be used on whatever you want. For example, a personal loan might be used to fund a wedding, home renovation, vacation, or help during an emergency.
A personal loan’s freedom comes with one major drawback: it’s unsecured. An unsecured loan means that you don’t have to offer anything as collateral. Since the loan lender is taking on more risk, it’s standard for unsecured loans to have a higher interest rate than secured ones. Personal loans come in various term lengths, usually 60 months or less, and varied loan amounts.
Student loans are a standard method of paying for college, graduate school, or other forms of higher education. You can take out a student loan with the federal government or shop around and use a private lender.
A federal student loan is usually better as the payments are more flexible. The government is more likely to offer deferment, forbearance, and forgiveness than a private lender.
However, federal student loans never expire as they have no statute of limitations. Taking out a federal student loan means that you’ll be paying it back regardless of how long ago it was or your current financial situation.
Auto loans are what they appear to be: loans that you use to pay for an automobile. Unlike personal and student loans, a car loan is considered secured. You’ll have to offer the vehicle that you’re buying as collateral. If you default, the loan lender can legally seize and sell the car to cover the loan balance.
The good news is that interest rates are usually lower for auto loans than for personal loans. Since a lender can make a legal claim to your vehicle, they’re taking on much less risk if you were to default. The terms of an auto loan usually max out at 72 months, but the occasional exception with a higher number of months is possible.
Mortgage loans operate in a very similar way to auto loans. You’ll be given the money to afford the house you’re buying (minus the down payment you make) and slowly repay the total amount over the life of the loan. The house will be offered as collateral and can be foreclosed if you were to default on the loan.
The main difference between the two loan types is that there are way more mortgage options. Government agencies such as the Federal Housing Agency (FHA) and the Veterans Administration (VA) offer mortgage loans for qualifying applicants.
Mortgage rates tend to be a more reasonable amount of money than other loan rates, and many loan payment calculators and mortgage calculators can paint a rough picture of what to expect. The mortgage interest rates are among the lowest interest payments because the loan terms are the longest. A mortgage repayment term lasts a number of years, typically between 10 and 30 years.
Debt Consolidation Loans
Debt consolidation loans are used to help pay off one or more debts that have a high interest. These loans are best used when someone has racked up a lot of money with multiple credit cards. Instead of juggling the balance on each card and incurring interest penalties, you can simply bundle them into one monthly payment.
The terms and interest rates of a debt consolidation loan are the most varied on this list. Each lender will have its preferences and conditions for these loans. Generally, the interest rate will be higher than a personal loan but lower than a credit card. The terms are also relatively short and typically don’t last for more than a few years.
Home Equity Loans
Home equity loans are quite different from the other options on this list. You’ll be borrowing a percentage of the home equity that you own in your home. The money is given out in a lump sum upfront, and you pay it back in a term that usually lasts between five and 30 years. Most often, you’ll pay the total interest at an annual interest rate in monthly loan payments, and the monthly payment amount is tied to either a variable or fixed interest rate.
It’s easiest to think of a home equity loan as a second mortgage.
The critical difference between a home equity loan and other options is that they are considered revolving credit — the home equity loan functions as a line of credit similar to a credit card. You’ll be able to draw from the credit line as needed during a “draw” period and pay interest on however much you borrow until the period closes.
The bottom line.
If you’ve taken out a loan, you’re not alone. While you may have many years left on your loan term, you can stay on top of your finances by calculating your monthly payments in a few simple steps.
No matter what type of loan you have, following these steps can help you prepare your monthly finances and focus on the bigger picture. For more business and financial content, explore additional resources at Entrepreneur.com.