Would you believe me if I said the typical American young professional is paying 2% more interest on their debts than they should be?
It’s not you though, right?
Let’s say this is actually true… you may think 2% is not a big deal. That may be the case if you only have a $5k debt… but many young professionals we encounter owe $500K+. At this level, 2% is HUGE. It amounts to over $800/mo in additional interest – typically going to Wall Street or Uncle Sam. Not cool at all.
Current Debt Figures & Facts
According to the Federal Reserve May 2015 Report, student loan debt is over $1.3 trillion. Vehicle loans are at almost $1 trillion. Revolving credit (mostly credit cards) is over $800 billion.
The average interest rate for auto loans is 4.53% (new car, 48 months, commercial bank) while credit cards are 11.98%. Student Loan rates are often greater than 6%.
Now, these are only averages. In my experience, I have seen smart people paying well above average rates often simply because they didn’t pay attention to them over time. Are you paying close attention to your debts?
Current Best Rates
Never settle for average. Your goal should be to pay the least amount of interest possible. And this involves making sure you have the most competitive interest rates on your debt at all times.
What are the most competitive rates right now (July 2015)?
Credit cards are easy… they’re all terrible! You shouldn’t carry a credit card balance… period! If you do, knocking that out must be your first priority. And once you do, never carry a balance again!
Auto loan rates with competitive lenders are currently in the low 2% range. For example, USAA currently offers 2.25% on 48 month loans – new or used cars. State Farm and BB&T have similar rates. Often, your best bet is a credit union for used cars and dealer lending for new cars. But, ultimately, it depends on the specific lender.
Student loans rates held by the government are what they are. However, refinance has become a totally viable option with multiple lenders to choose from. The best student loan fixed rates are 4.5% for 10 yr payoff and 3.5% for 5 yr payoff. DRB & SoFi both offer rates in this range.
Also, DRB offers a unique program specifically for medical residents that is designed to work like income based repayment. If you qualify, they will allow full refinance during residency and much lower payments until completion of training.
Mortgages are more complex – with all the closing costs, points, and PMI. But, to give you a general idea, current competitive mortgage rates are between 2.75% – 4%. The lower rates are for ARM loans (shorter term rate lock) and the higher rates are for the 30-year fixed.
Consumers Lose & Lenders Win
In our current economy, most people are paying over 6% on their student loans when the best rates are 4%. Many pay 4.5% for an auto loan when 2.5% is available right around the corner. Often, people have mortgage rates at 5% when the best comparable rate is 3.5%. This results in wasted opportunity (for the consumer) and extra profits (for the lenders).
How Loans And Interest Work
Think of a loan as being the opposite of an investment. With an investment, you put your money into something and expect interest in return. When you take out a loan, somebody else is investing in you and expecting your interest in return. The lender will rarely offer lower rates… in some cases, they increase rates.
Interest rates are confusing and typically favor the lender. The interest rate you see may not be the actual interest rate you pay. Lenders often quote APR, and APR does not take into account interest on interest (compound interest). The interest rate you want to look for on loans is the APY. This rate is the annualized interest rate that includes the interest charged on interest that occurred during the year. The variance in APY and APR depends on how often interest is compounded.
For example, interest is only compounded annually, the APR will be equal to APY because there was no additional interest charged during the year and, therefore, no interest to charge on the interest. Alternatively, if interest is charged daily, your APR (rate the lender quotes) will be lower than your APY (actual rate). So, if your rate is 6% APR and interest is compounded daily, your APY is actually 6.18%. This extra 0.18% difference may not seem like a big deal, but it will add up to be a considerable sum over longer periods of time.
Albert Einstein said, “Compound interest is the eighth wonder of the world. He who understands it, earns it.. he who doesn’t.. pays it.”
What Can You Do?
For starters, you should be keeping an eye on interest rates in general and compare them to your current rates. If you don’t want to do this, hire advisors that do it for you as part of their services. Rates are always changing and it’s easy to let this slip through the cracks. Many consumers get busy and/or don’t have good advisors and don’t realize when they are missing an opportunity.
If your rates are higher than the competitive rates listed above, maybe it’s time to take a deeper look at the available alternatives – it doesn’t hurt to look. Generally, the larger the debt, the more rate variances will impact your dollars. Start with your largest debt first and make sure it’s competitive.
Ok – let’s say you owe $20K on an auto loan that has an APY (actual interest rate) of 5% with 4 years left. You read this article and realize it may not be the most competitive rate. You do some researching and find you could refinance for 2.5% without any other fees. Now, it’s all about comparing the possible refinance with your current rate. I use an app from Bankrate that will show current competitive rates and also runs example payment schedules. The app allows me to calculate the interest savings at the lower rate = $1070.65. Not too bad!
The home loan scenario is often more challenging to analyze because you must account for new loan closing costs if you refinance. Basically, you want to find out how quickly the savings in interest pays off the closing costs of a new loan (your break even point). There are applications for this, as well, that you can use.
Aside from interest rates alone, many people do not have the best loan for their situation. For example, if you have a 30 yr mortgage and are certain you will only keep the home for 5 more years more, you should be considering the 5 or 7 yr ARM because their rates are even lower.
Also, keep in mind many of the “physician loans” have higher interest rates than normal. You should keep this in mind as you build equity and gain access to many more types of loans.
Even more complicated is the student loan refinance scenario. In reality, you must consider 3 options instead of the normal 2: Keep them as-is, refinance, or go for a forgiveness program. Ideally, you consider the pros and cons of each scenario and make educated decisions. There is plenty of opportunity to improve here because most existing student loan rates are very high compared to the most competitive rates. But, you must also consider the pros and cons of each option outside of the rate difference alone.
Americans clearly have considerable outstanding debts… particularly young professionals that were forced to take out big student loans. Make sure you are aware of the market rate ranges for each of your debts. If you don’t have the lowest interest rate possible, run the numbers on refinance vs. keeping as is. Don’t forget to consider all the pros and cons of the debts under consideration. Be aware of the basics of how debt and interest rates work and keep track of it.
Some of you may have credit score issues that cause rates to be higher than normal – that’s ok! If this is you, do everything you can to get your credit score back up so that you can obtain the most competitive rates.
We have free tracking documents that will help you begin to track this type stuff – just enter your email at the top of this page to receive these tracking documents. Take 10 minutes to fill out the net worth tracker for this month. Note your interest rate for each debt. If one is higher than competitive rates, do some quick research to see what alternatives exist.
Word of caution… keep in mind the alternative lenders you consider will almost always say they are “better” or “the best” – don’t just take their word for it – do your own comparison or have someone financially unrelated to the deal do it for you.
Let us know your results. We would love to hear about your improvement!