Originally posted by: Penth
Because with most loans you don't pay 4.9% of each monthly payment to interest. For example. The loan I looked up was 5.49%. 36 payments of 241.53. On the first months payment $36.60 goes to interest, or over 15%. After 28 payments, only $9.72 goes to interest, or 4% and it only goes down from there. So the last 9 months I would pay less interest for my loan than I would earn having the money in the bank. So it would be stupid of me to put out $2173 to pay off the loan 9 months early. It would actually cost me more and I would have less padding in my bank account.
The interest rate does not refer to the amount of interest you pay per month. It refers to the annual rate you pay in relation to your current balance. If you have a 5.49% rate on your loan, this means you will pay 5.49% compounding interest per year-- it does NOT mean that 5.49% of your payment goes toward interest. So, since your loan is $8,000... the first payment you'd pay $8000 * 0.0549 / 12 (balance * interest / # of months in a year) in interest, which is where they get the $36.60 from.
So as stated earlier in this thread, yes it's true you pay more interest up front but only because the balance of the loan is higher. So if you have $2,173 left on your loan then you are still paying 5.49% interest on the balance. Therefore, if you have $2,173 in your bank account accruing 4% interest, you will still come out behind in the end if you keep it in savings rather than paying off the loan.
For example, given your scenario, you'd pay this off in 10 payments (the last payment is only a partial payment) -- this would pay off your $2,173 in full. Now, that same $2,173 in a 4% savings account would earn you $73.53 over those 10 months, plus you'd deposit about $191 from the remainder of the last partial payment. Your ending balance would be about $2,437 at the end of 10 months.
Had you withdrawn money from savings and paid for the loan in full, then began depositing that $241.53 each month into a 4% saving's account, you'd end up with about $2,451 at then end of 10 months. As you can see, you'd have $14 more dollars by paying off the loan first. Granted, that isn't a lot of money but you still come out ahead.
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