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The Value of Good Credit
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THE SCENARIO
It's common knowledge that when your credit score is good, lenders are more eager to lend money to you on favorable terms than when it's not. The differences in interest rates and fees can add up to quite a lot of money over the long term - and the higher payment amounts make it harder to pay those bills.
Let's take a look at one hypothetical borrower with two different borrowing rates. To keep things simple, we'll focus on interest rates and ignore the extra fees that might be required of someone with poor credit.
The question: I want to borrow $200,000 to buy a house. How much more do I pay over the life of the loan if the lender charges 6.5% interest instead of 4.25%? Both loans are 30-year, fully amortizing loans.
THE SOLUTION
This one is pretty straightforward, and has several parts.
- Find the payment at 6.5%
- Find the total paid at 6.5%
- Find the payment at 4.25%
- Find the total paid at 4.25%
- Find out how much more the higher rate costs overall.
First things first, make sure the calculator is using 12 Payments per Year.
Step 1: Payment at 6.5%
N: 360 (The loan lasts 30 years, which is 30 x 12 = 360 months)
I/YR: 6.5 (The interest rate on the loan is 6.5%)
PV: 200,000 (I'm borrowing $200,000)
PMT: (This is what I'm trying to find)
FV: 0 (The loan amortizes fully)
The 6.5% loan has payments of $1,264.14 per month.
Step 2: Total paid at 6.5%
Overall, I'm making 360 payments of $1,264.14.
360 x $1,264.14 =
$455,090.40 in overall payments.
Note that I need to type in the payment amount before multiplying it by the number of months. This is because the $1,264.14 is actually $1,264.136046986, and multiplying
that number by 360 will lead to a number that's
slightly off. Since I can't send fractional pennies to the bank, I have to use the rounded number when I multiply.
Step 3: Payment at 4.25%
N: 360 (The loan lasts 30 years, which is 30 x 12 = 360 months)
I/YR: 4.25 (The interest rate on the loan is 4.25%)
PV: 200,000 (I'm borrowing $200,000)
PMT: (This is what I'm trying to find)
FV: 0 (The loan amortizes fully)
The monthly payment for the 4.25% loan is $983.88.
Step 4: Total paid at 4.25%
If I make 360 payments of $983.88, I pay a total of 360 x $983.88 =
$354,196.80.
Step 5: Difference in total payments
With the 6.5% loan, I pay a total of $455,090.40. With the 4.25% loan, I only pay $354,196.80. If I get the higher-rate loan, I pay a total of $455,090.40 - $354,196.80 =
$100,893.6 more over the life of the loan. Considering I only borrowed $200,000, paying an extra $100,000 seems like a lot to me.
What do you think? Did you expect this result? Do you think I used the wrong interest rates? If so, what rates would be more realistic? Let us know in the comments!
