In this part I’ll demonstrate how people use bad math to convince you that a simple interest loan is better.
Let’s say I put $1000 into a bank account with a 7% interest rate. One bank account pays 7% in simple interest and the other pays 7% in compound interest. Compounded monthly.
As you can see you’re going to have significantly more money after 30 years with compound interest. Now, imagine you would owe that money rather than recieve that money. Obviously you’d rather owe the $2000 accumulated through simple interest than the $7000 accumulated through compound interest, right? Obviously you want to owe less so using the “savings” example to illustrate the “loan” you can be tricked into thinking simple interest is better.
But since you read the previous two posts you know something is not right. The “savings” example is not relavent to loans. The reason isn’t entirely obvious. It’s because when you’re saving money the principle balance is increasing where when you pay back a loan the principle balance is decreasing.
If you want to compare the savings example to a loan example, flip the chart vertically. Now it looks like the charts you saw in the last post. The red line starts at the same point as the blue line but goes down progressively faster.
By reducing the amount of principle in a compound interest loan you reduce the amount of interest owed the next month and the next month, etc until the loan is paid off. In a simple interest loan you never reduce the amount of interest owed. In order to progressively put more money towards principle in a simple interest loan you have to progressively increase your monthly payment. In order to progressively put more money towards principle in a compound interest loan you can maintain a monthly payment that has a non zero amount applied to principle at the beginning.
So now you know why you may have been tempted by a simple interest loan so you can tell the insurance (or mortgage) agent why his presentation is misleading.
The only time a simple interest loan is worth it is if the interest on the simple interest loan is significantly less than any compound interest loan you could get. If you can only get a 7% rate for a conventional mortgage but someone is willing to give you a 4% simple interest rate loan, then it may save you money.
But do the math before you sign any papers. You can see how easy it is to be fooled if you don’t.
