Author: Emily Tierney
In a low-interest rate environment one of the best ways to “earn” return is to pay off fixed interest rate loans. Like the old adage, “a penny saved is a penny earned”, paying off a fixed interest-rate loan may give your personal net worth the same boost as earning investment interest income.
The interest saved by paying off a fixed interest-bearing debt guarantees a personal rate of return. In today’s world, it is difficult to find investments that guarantee a rate of return. Retiring debt not only guarantees return, but also provides extra monthly cash flow because you no longer have those payments.
How is this considered “return”?
Let’s say you have a $15,000 car loan with a fixed 4.5% interest rate. You are paying roughly 4.5% of your average loan balance towards interest annually. Interest is what you pay to your lender to borrow money over time. Interest payments do not decrease your loan balance. If you pay off the loan balance completely, not only do you have more money available each month, you also saved yourself 4.5% annually on the loan balance. Making extra payments towards this car loan will help to reduce your annual interest expense and will shorten the term of the loan by paying the balance off quicker.
How does making extra payments decrease the annual interest rate over time?
First, you’ll want to check with your lender to ensure your additional payments go towards principal and not towards future interest payments. When you make additional payments that go towards principal, you are decreasing your loan balance quicker, thereby shortening the term of the loan. When you pay off the loan balance quicker, you shorten the length of the loan. This reduces the interest expense you would have been paying over the remaining term. In other words, when you make an extra principal payment, the interest on the next monthly payment will be less, so more of that next monthly payment will go towards the principal, decreasing the balance faster.
What if you have multiple loans with different interest rates?
Consider trying to aggressively pay back one loan at a time and paying minimums on other loans. In other words, get focused on one of the loans and put any and all extra money towards this debt while paying the minimum amount towards the other loans. When the first debt is paid off, get aggressive about paying down the next debt. By focusing on one loan at a time, you gain more traction than trying to spread yourself thin and pay down too many things at once. Some say prioritizing loans from the lowest balance to the highest balance is most effective, while others say prioritizing loans based on the highest interest rate is. I personally suggest paying off your lowest debt balances first to keep up the motivation.
Isn’t it good to have a low interest rate on a loan?
It’s better to pay lower interest rates than higher interest rates – yes. Having a low interest rate in a rising interest rate environment is good, however ridding yourself of those debt payments is even better!
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