Personal Loans
How a Canadian loan charges interest
In words you can understand!
Personal loans charge simple interest and are very “simple” to understand. Simple interest means that interest is charged for a specified period of time on a specific amount of money. For example, simple interest for a loan of $100.00 at 10% for one year is equal to $10.00 per year.
There is no need to complicate it any more than that. It’s simple. Let’s say you borrow $25,000.00 to buy a car and you agree to pay the bank back over a five year period (60 months) at an annual interest rate of 5%. To calculate your monthly payment is very easy.
First, we must determine the amount of interest that will be charged for one year. In this case, we multiply $25,000.00 by 0.05%. The total interest for one year on this loan is $1,250.00. Since our loan is to be paid back over 5 years we must multiply the annual interest ($1,250.00) by 5. Therefore, the total interest to be paid over 5 years will be $6,250.00.
Next, we add the total interest ($6,250.00) to the principle amount borrowed ($25,000.00) and arrive at a total loan amount of $31,250.00.
The last step is to divide the total loan amount ($31,250.00) by the number of months we have to pay it back (5 years = 60 months). The total monthly payment will be set at $520.83.
It is really important that you notice something about simple loans. There is absolutely NO incentive for you to pay them back faster than you have to. The total interest for 5 years has already been figured into your total loan amount so whether you pay this loan back in 10 months or 60, you will still pay back the entire $31,250.00. Even if emotionally it “feels” better to pay one of these loans out early because you “have the money”, it simply does not make sense.
By making extra payments to a simple loan, you are giving the bank money that you could use to temporarily reduce interest on another one of your liabilities and there is no benefit to you for doing so. I promise you that they will take it if you give it to them, but if you are going to do that you might as well attach a Christmas card to the cheque since you would be giving the bank a pretty nice and unexpected gift!
