Need to make a big purchase, like a house or a car? Take out a loan. Want to go to college? Take out a loan. Need to cover other expenses, like home renovations or an adoption? Take out a loan. Want to consolidate your debts? Take out a loan.
Loans are a fact of life in our country. They’re convenient and useful. They can also be really dangerous to financial health.
And the math behind loans can be pretty daunting (which is why there are some great loan calculatorsout there on the interwebs). That’s where a teeter-totter comes in. (Stay with me on this my literal friends; it’s a metaphor.)
A formula or equation is like a teeter-totter — that piece of playground equipment that requires one person on one side and another on the other side. (You may call it a see-saw, but I think teeter-totter is a funnier word.) If an adult sits on one side of the teeter-totter, while a child is on the other side, what happens? Unless the adult is really small or the child is really big, the child will be up in the air right? In other words, the teeter-totter will not be balanced.
That’s exactly how many mathematical formulas and equations work. If you have one large variable, the outcome will likely be larger. If one of your variables is reduced, the outcome will be smaller.
(Okay, so this really depends on the operations that you’re using, which is what some of you smarty-pants math readers have already noticed. Still the idea of balancing the equation holds.)
This means that simply thinking about math concepts that define these loans can help you make smart decisions. Here’s how — without any numbers at all!
Know thy variables
As with any math application, the variables matter — big time. These are the pieces of the problem that can change from situation to situation. (Yes, they’re the letters in a formula or algebra problem, but don’t let that scare you.) Because there are so many different kinds of loans out there, paying close attention to these variables is critical.
So what are they?
1. First off, there’s the principal or the total money borrowed. This amount completely depends on what you need the funds for. You might borrow $5,000 from your home’s equity to purchase new appliances for your kitchen. You might borrow $25,000 to start a graduate or undergraduate degree. Or you might take out a $250,000 mortgage to buy a new house.
2. Next comes the interest rate or the amount that you’ll be charged periodically for the privilege of borrowing the money. Sometimes, like with federal student loans, this rate is already set. But most of the time, you can shop around for the best interest rates.
3. Then there is the term of the loan or the amount of time you’ll have to pay it off. Again, this depends on the loan itself. You may choose a 10-year, 15-year or 30-year mortgage. Your car loan may be due in full by the end of three years.
How low can you go?
These variables matter, because they determine three things: how much you’ll be paying for the loan in all, how much your monthly payments will be and how long you’ll be paying off the loan.
For most situations, it’s a good idea to keep all of these variables as low as possible. The smaller the loan, the quicker you’ll pay it off. The lower the interest rate, the less you’ll pay in all, and the shorter the term, the less interest you’ll pay.
All of this works because of math. But this is one of those situations when understanding the concept behind the math is as useful as doing the calculation itself. If you can remember how formulas work (generally speaking), you can see why it’s important to keep the variables as small as possible.
— A large loan increases the total interest (not necessarily the interest rate) and time it takes to pay it off.
— A high interest rate increases the total interest paid.
— A longer term increases the total interest paid.
Balancing the teeter-totter
Here’s where the teeter-totter comes in. If you want to pay off the loan in a short period of time, your interest rate and/or your principal must be low. If you want to borrow a large sum of money, you’re term is probably going to be longer (unless, of course, you can make really large monthly payments).
In other words, whatever you do to one side of the teeter-totter will have an effect on the other side of the teeter-totter.
Pick and choose
But one or more of your variables may be set. For example, you won’t be able to negotiate a lower college tuition (unless you choose a different school), and if you are living on a fixed income, the monthly payment you can afford will likely dictate the term of your loan.
So that’s when you need to consider how to lower the other variable(s). This is where the math comes in. If your principal is constant, try to lower the interest rate or term. If your term is set in stone, look at borrowing less or shop for a lower interest rate. And if you can’t get a smaller interest rate, consider lowering your principal or shortening the term of your loan.
See? You don’t necessarily need to scribble down the math to have an idea of how to choose a good loan. Yes, you will need to do the math at some point. But considering the basic variables in a loan can put you on the right path for making good financial decisions.
Does the teeter-totter metaphor work for you? How can you see it in other math applications? Share your stories in the comments section! (And if you have questions about the math behind loans, ask those, too.)