Before you buy a home or make any other major purchase that requires you to take out a loan, you need to know how much you can afford to spend. Most people can estimate how much they can pay each month toward repaying a loan, but it can be hard to translate that into a target price for the purchase they're looking to make. With the help of a handy calculator, you can take your interest rate and term of your loan and get the information you need about not only how much you'll pay but also the amortization schedule of principal and interest throughout the course of your loan. Let's take a closer look at the calculator and how it works.
Understanding what affects the loan payment amount
If financing were free, then figuring out a loan payment amount would be trivial. For instance, say that you borrow $1200 and want to pay it back over 12 months. Without interest, all you'd have to do is divide 1200 by 12 and get $100 per month as the loan payment amount. Sometimes, you can actually find free financing, through promotions like 0% introductory rates on credit cards and similar offers.
When you introduce interest into the mix, however, things get a lot more complicated. With interest, there are two general rules to follow:
- The higher the interest rate, the larger the loan payment amount will be.
- The longer the term, the lower the loan payment amount will be, but at the price of a rising total amount of interest you'll pay over the course of the loan.
Those two rules are pretty clear, but it's still useful to understand them. Higher interest rates mean that you'll incur more interest on a loan, and so you'll have to make bigger payments in order to repay it. By contrast, if you lengthen the amount of time that you have to repay the loan, you'll be able to pay a smaller amount of principal each month in order to get the loan repaid on time. However, because your loan balance will get paid down more slowly, you'll have to pay more in interest.
How rising interest rates can crush the American dream
The best example of how this works is in considering mortgage loans, where many people stretch to the limit in order to buy as expensive a home as they possibly can. For instance, say that you are thinking about buying a $200,000 home, and mortgage rates are at 4%. For a 30-year mortgage, your monthly payments will be $955. You'll pay just under $144,000 in interest over the course of the loan.
Now say that interest rates rise to 5%. In that case, you'd have to pay $1,074 per month in order get the same $200,000 30-year mortgage repaid. More importantly, if your bank had determined that the most you could afford for a monthly payment was $955, then you might not even get the mortgage loan at all.
In that case, you'd have a couple of choices. First, you could reduce the amount you'd borrow. Cutting your mortgage loan to $178,000 would restore the monthly payment to its previous level -- but it would come at the cost of having to look for cheaper housing. The alternative is to try to find longer-term financing. A 40-year mortgage on $200,000 at 5% would produce monthly payments of $964 -- but you'd spend almost $263,000 in interest over that period, or very close to double the total interest on the original loan at 4%. Moreover, you'd have 10 fewer years to take those payments and use them for other purposes, such as saving for retirement.
If you're in the market to make a major purchase, enter some numbers in the loan payment amount calculator above to give yourself a sense of what you're committing to. By knowing how various purchase prices translate into monthly payments, you'll have a much better sense of what you can truly afford before you make an offer.