If I'm borrowing say, $5,000 and plan to make $200 payments each month, which of these loans would end up being the better option? I believe that the interest on either will accrue daily rather than monthly.

  • 4-year term at 6.50% with minimum payments at $118.57
  • 5-year term at 7.25% with minimum payments at $99.60

I'm wondering how that interest rate plays into an early payoff plan. Unless I'm looking at this wrong, it seems that since more of the payment will go to paying down the principle on the 5-year loan, it may be the better option even though that interest rate is higher.

  • This looks a lot like a homework problem. – Dilip Sarwate Apr 13 '18 at 17:37
  • Hahaha! Yeah, I've been trying to figure it out, but it's been a while since I've done this kind of math :P – devtanc Apr 13 '18 at 17:38
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    Since you are making payments above the minimum, the lowest interest rate wins. – Pete B. Apr 13 '18 at 18:08

It is an interesting question. I can see how you might think that you are paying more principal with a $200 payment on the 5-year loan vs the 4-year loan, since with the 5-year loan you are paying $100.40 extra, and with the 4-year loan you are only paying $81.43 extra.

However, what you fail to understand is that the minimum payment of the 4-year loan already includes more principal inside it than the minimum payment of the 5-year loan does.

At 6.5%, the interest charge for the 4-year loan in the first month is $5000 * (.065 / 12) = $27.08. That means if you pay the minimum payment of $118.57, you are paying off $91.49 of principal. And if you make a $200 payment, your principal payment is $172.92.

For the 5-year loan at 7.25%, the interest charge in the first month is $5000 * (.0725 / 12) = $30.21. With your minimum payment of $99.60, only $69.39 is for principal. If you make a $200 payment instead, your principal portion jumps to $169.79.

As you can see, the 4-year loan is better in your scenario. And this makes sense: You are suggesting making an identical payment to either loan, so the one with smaller interest charges would certainly be better.

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    Ah, I see where I was looking at it wrong. This is great! Thanks! – devtanc Apr 13 '18 at 18:39

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