LINES vs LOANS

One of the greatest epiphany would be realized in this section. One should clearly understand the difference between credit ‘lines’ and ‘loans’. Credit lines are revolving credit whereas loans are one directional. A credit card with 21% APR in several cases is better than 4% mortgage. Mortgage is amortized and one pays hefty interest upfront. In fact, it takes almost 20 years on a 30-year mortgage to start paying equal payments for the principal and interest. And a typical home owner ‘refinances’ their home in 5 years which leads to switching the clock back to the beginning. This is great for banks but not for customers.

Loans

Typical loans like mortgage, student loans, auto loans or personal loans are loans with amortized interest payments. The interest is calculated for the term of the loan and then distributed unequally in the loan payments. One pays a higher percentage of interest in the beginning compared to the principal amount. The interest ratio keeps decreasing with time. However, banks trick you into refinancing and your interest cycles starts all over again. Always remember, there are two sides of the same coin. A typical amortization graph is shown below:

In the beginning of such loans, one ends up paying majority of money in interest. Is that in the interest of banks or their customers? Let’s look at how the numbers get laid out for a typical mortgage of $300,000 for a house when seen at the end of 5 years.

Total payments made towards the loan = $91,203

Payments applied to principal = $26,526

Interest Paid = $64,677


How is this 4.5%?


If it was a true 4.5% simple interest, the numbers would have been:

Total payments made towards the loan = $91,203

Payments applied to principal = $70,680

Interest Paid = $20,520


What happens in 5 years? An average American either move to a bigger home or get it refinanced. Did you realize that you just paid the bank huge amount of interest while almost not impacting your principal? Who won the game here?

Lines

Lines of credit can be in the form of personal credit cards, business lines of credit or home equity lines of credit (HELOCs). It is a revolving credit unlike loans which are one directional and money cannot be taken out when there is an emergency. If money cannot be taken out during emergency, people have to maintain a savings account for rainy day. Lines of credit tend to have higher rates of interest and smaller minimum payment amounts. If used smartly, they are always better than loans as the interest on these lines are based on ‘daily’ balance. Moreover, the moment you make a payment for a line, you can access that same amount immediately unlike loans.

One can transfer a loan to a credit line and save loads of interest.

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