A Review of Part 2
Put some life into your personal finances was the message in Money Math – Part 2. Learn the Rule of 72 to see how long it takes to double your money while investing, with compounded earnings. Then, take the worry out of long-term investing, such as in your retirement account, by utilizing the factor of dollar cost averaging.
Also, be aware of the effect of inflation. And learn to avoid debt and fund your emergencies with an adequate amount of savings.
Notes on Useful Debt and FICO Scores
The FICO Score was developed by the Fair Isaac Corporation as a standard for making fair and accurate decisions about credit worthiness. You will need to stay (or work up to) at least a score of 670 to be considered a good credit risk. A much higher score will help the interest rate a lender feels they need to charge to protect their risk related to a payback of the loan.
Your FICO Score is calculated based on the following:
- 10% New Credit
- 15% Length of Credit History
- 10% Credit Mix
- 35% Payment History
- 30% Amounts Owed
Yes, there may be an occasional error in reporting, but lending institutions are pretty good about reporting to the various credit bureaus.
This is good Money Math to know if you intend to borrow money to get a vehicle, a house, or any other item of value more than your current resources.
Your FICO Score will affect your rate of interest for any loan!
Math in Loan Interest
There is a lot of critical information hidden in the fine print of any loan. Be sure to read as much as you can and ask questions about any unclear statements.
One term that has gotten a lot of press and legal attention is the APR or Average Percentage Rate of Interest. The fine print should explain if the interest is a flat amount or based on the unpaid balance and if there is a penalty for paying the loan off early.
The amount of the loan and the time to repay the loan can have a dramatic effect on how much interest (the cost of the loan) that you will pay. This is a BIG picture that you need to keep in mind when getting a loan, especially for a house.
Using an online loan calculator, you can verify the following calculations regarding a mortgage loan on a house. I will use $200,000 as the value of the mortgage loan and 6% as the interest rate. Currently, the rates have been higher, which means that my examples may be understating the current reality.
To show the effect of the amount, I will show two calculations for a 30-year loan on the $200,000 and with a 20% down payment which would reduce the loan amount to $160,000:
$200,000 at 6% interest over 30 years = $231,636 in Interest Expense.
$160,000 at 6% interest over 30 years = $185,341 in Interest Expense.
That $40,000 reduction in the amount of the loan saved $46,295 in interest over 30 years!
To show the effect of time, I will reduce the payback period from 30 years to 15 years, which is a highly recommended plan:
$200,000 at 6% interest over 15 years = $103,789 in Interest Expense.
$160,000 at 6% interest over 15 years = $83,031 in Interest Expense.
By paying off the loan in 15 years rather than 30 years, you will save $127,847 in interest expense on the larger loan and, with the amount reduction, $102,310 in interest expense.
Remember that the interest expense is the cost of the loan! Would that $100k in savings be of interest to you? Or do you like paying the bank?
Transportation Costs Calculations
Our transportation options are affected by our options for travelling to work, proximity to shopping needs, and our assets available for purchases and maintenance.
Where you live can make a big difference. Do you have public transportation available? Do you live in the country or in a small town where your commute could take up to an hour one way?
You need some perspective calculations for making good decisions about your transportation needs. I know this is a sensitive area where egos can sometimes influence your decision. Driving a new vehicle with a warranty comes at a hefty cost that needs to be tempered with the financial effects over time and the cost of other options.
You can make your own assessments for using public transportation, if you have that option. Most of the population in the U.S.A. does not. Therefore, I will offer some comparison calculations for buying a new vehicle versus a used vehicle.
In my eBook, Saving, The Day!, available on Amazon Kindle, I note the cost comparison of new versus used over a 20-year period. For this post, I will use the length of a new car loan for over 6 years at two interest rates, which are affected by your FICO Score.
Using a Good FICO Score, of over 670, you might be able to get a $40,000 new vehicle loan for 5% interest. (I know there are ads for 0% interest loans but watch the fees that get added—remember to read the fine print!) The calculation of interest would be:
72 monthly payments of $644.20 = $46,382.21 in Total Payments, which means the interest cost would be $6,382.21 or about 16% of the original cost of the vehicle.
If you have a Below Average FICO Score, you might have to pay 10% interest on that new car loan. Hey, I don’t make the rules, the bank does. That would mean:
72 monthly payments of $741.03 = $53,354.41 in Total Payments, which means the interest cost would be $13,354.41 or about 33% of the original cost of the vehicle.
Paying cash for a vehicle should start to look smart!
With few able to pay cash for a vehicle, I will offer the optional cost of buying a used vehicle. Be sure to have a mechanic look at the vehicle for potential repairs. The small fee will pay for itself with the knowledge gained from a mechanic’s perspective. You should be able to find a decent used vehicle for about half of the cost of a new vehicle. So, I will use $20,000 as the cost to finance on a used vehicle loan and the expectation of repairs costs each year that are outside of any warranty of about $1,000 per year, which could include tires, brakes, and other items. Expecting no repair costs is unreasonable.
Since banks like new vehicle loans over used vehicle loans, you can expect to pay around 14% interest, perhaps less with a higher FICO Score. And the loan period available is shorter. I will use a loan period of 3 years. The cost calculation would be:
$20,000 at 14% interest over 3 years = $683.55 per month x 36 months = $24,607.89 in Total Payments. The interest expense would be $4,607.89, about 23% of the original vehicle value.
With regular maintenance, a used vehicle should last 6 years, which means that the cost to maintain this used vehicle would be about $6,000 over that time. So, the cost of this used vehicle over 6 years would be about $30,608.
Using Money Math to be a better steward of your resources, the comparison between buying a new vehicle versus a used vehicle is very important for your long-term welfare. Consider the following calculations:
A $40,000 new vehicle with interest = $46,382.
A $20,000 used vehicle with interest and additional maintenance cost = $30,608.
The potential savings for buying used vehicles versus new vehicles = $15,774. That is 51.5% additional cost to buy new vehicles! If you buy a vehicle every 6 years over your lifetime, that will mean about 8 to 10 vehicles, the difference will amount to a HUGE amount of money!
If you budget for vehicle maintenance, you have the potential to save enough money to build a decent retirement account! Of course, paying cash for a vehicle will eliminate interest expense. The age and mileage of the vehicle will affect the price and potential for repair expenses.
Due Diligence to Reduce Risk
Now you have become aware of the options for useful debt based on developing credit worthiness. Keep the debt amounts low and pay off ahead of schedule and savings on interest expenses will increase and improve your long-term cash flow.
On my next post, Money Math – Part 4, I will discuss calculations to preserve your assets and reduce the risk of loss from accidents, illnesses, and investments.