Decide whether the following statement makes sense or is...

Decide whether the following statement makes sense (or is clearly true) or does not make sense (or is clearly false). Explain your reasoning. The interest rate on my student loan is only 7%, yet more than half of my payments are currently going toward interest rather than principal. Choose the correct answer below. A. The statement does not make sense. Principal is always paid off entirely before any payments go toward interest. B. The statement makes sense. A much larger portion of every payment goes towards interest, regardless of the interest rate. C. The statement makes sense. The portions of installment loan payments going towards principal and toward interest vary as the loan is paid down. D. The statement does not make sense. For every payment, 7% goes towards interest and 93% goes towards principal.

Transcript

00:01 Let's look at some situations to think about whether or not these are true.

00:10 If we're placed in a scenario where we have a student loan with 7 % interest.

00:19 So there are four possibilities.

00:21 The first is that the principal is paid off first before paying the interest.

00:26 Second possibility is more of each payment goes to the interest rather than the principal.

00:33 The third is that the portion of the payment that goes to the interest and principal changes as the loan is paid off.

00:38 And the final is that each payment is split up to cover your interest rate and principal based on your interest rate.

00:45 So if you're at a 7 % interest rate like we do, then each of your payments would cover 7 % to your interest rate and 93 % to your principal.

00:54 So let's consider whether any of these are true, if any of them make any sense.

00:59 So 7 % interest on a student loan.

01:09 What you're going to be asked to do is to pay this back in equal amounts over some number of months.

01:19 So oftentimes it'll be, you know, over some many years, let's say, you know, 30 years, long time.

01:27 So 360 months.

01:28 And let's say that your actual loan is like $150 ,000.

01:36 Okay, so 360 months to pay off $150 ,000.

01:42 Now, the company that's loaning you the money wants to make some money off the fact that they are fronting you this loan.

01:51 And that's where the 7 % interest comes in.

01:54 So every year they basically charge you 7 % interest.

02:00 On the principle that you are trying to pay back, which is initially $150 ,000.

02:08 So you'd think that you'd be able to just multiply $150 ,000 times 7%, and then add that to the $150 ,000 that you have and be like, great, that's it.

02:21 But the reality is that the 7 % interest is every year that you have this loan, you have to pay percent interest.

02:31 So in the first year, sure it would be $150 ,000 initially, but then in the next year, you've only paid down a tiny amount of that.

02:40 So every single year, as you go through these, you know, 30 years, 360 months, you're going to be paying like more, you're going to be paying a lot of interest to cover your $150 ,000.

02:57 In fact, if you use like time value, money and do the whole equation, which actually find out is this ends up being almost $360 ,000, which obviously means about $210 ,000 will go towards interest.

03:19 So when we think about that reality, and then we try and line up these four possibilities, there's a few that we can knock off and say these are not true pretty quickly...

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