Teaching Students the Pitfalls of Simple Interest Loans


Simple interest loans sound so, well, simple. But teens need to know what to look out for when deciding on the terms of their car loan. Here is an extreme video I found where a woman gets completely ripped off by a simple interest car loan:

Of course this can happen with any high interest loan, especially if payments are missed. Problems can also arise with low-interest loans. I just feel so badly for this mom and the video reminded me of a Facebook post where a former student asked if she should buy a new, safer car for her baby-to-be and ditch her car loan that has a 24% interest rate.

24%??

But I'm getting off track. Yes, most high school students, and even a lot of young adults, don't understand that even a 1% interest rate difference can mean the difference of thousands of dollars over the course of a loan. But this is easy to teach. It's also easy to solve a simple interest equation in the classroom, and even a compound interest equation, when no payments are factored in. But this misses an important part -- those monthly payments. 

Let's compare some charts. Here is a graphic of a $10,000 loan paid off in $1,000 monthly increments at a 12% interest rate (1% each month): 



The $10,000 loan cost this person $10,590. The interest payment is recalculated each month based on what is left of the principal. Since the principal is less each month because payments are being made, the interest will be less each month. And here is the same loan with smaller monthly payments. Over the course of the loan, the borrower pays an additional $113.



When I had bought my car, the dealership quickly offered me a 66 month loan when I winced at the monthly payments on a 60 month loan. I thought they were doing me a favor. Turns out, I was doing them a favor. My payments were less per month with a 66 month loan, but this allowed for more interest to be assessed. Had I missed any payments, this interest would have been even more. This is what teens really need to understand before signing over their hard-earned down payments. 

Now here is the same $10,000 at a 12% simple interest rate with 2 missing payments:



Things come up. We need a new roof, the car we're paying for breaks down, we need to go on a trip to Disneyland... OK, this is where Wants vs Needs come in when teaching teens. 

When payments are missed, the missed interest is added into the principal. US law is now set up to prevent some of this from happening, but a "negative amortization" situation can happen when payments are missed. Here are the graphics side by side:



There is a student handout of this sheet in my dropbox.

So, what is there to do? Well, buy a car outright. OK, this isn't possible for most of us. Here are some realistic tips:

1: Shift student focus away from "debt is a way of life".
2: Reinforce the idea of never missing payments. 
3: Honest conversations about monthly payments given a teen's budget. (A loan shouldn't be stretched too far, but monthly payments shouldn't be so high that there is a possibility of missing payments if things come up.) 

I also found this great video on a way to never make a car payment. It's a little far-fetched (it talks about high-yield investments, which seem pretty pie in the sky to me), but it does an amazing job of giving students something to think about as they are weighing paying some of college up front vs. financing a shiny new car. 

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