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I work in finance at a large company.  We get leases and loans for large purchases, just like a consumer.  When we sign a new lease or loan contract, they often have balloon payments, just like consumers.  Part of my job is to determine whether it is a better deal for the company to lease or buy new equipment, and balloon payments are always favorable compared to loans without balloons, and they almost always are to consumers to, despite everything bad you may have heard about them.

First, it is important that everyone knows what a balloon payment is and how balloons work.  A balloon payment is a deferred amount that is paid in lump at the end of a loan/lease.  For my company, those lumps can be as high as $3,000,000 or more depending on the size of the equipment.  For consumers, the balloon is usually in the thousands of dollars range.

Why Balloons Are Good:  The time value of money demonstrates that deferring payments is beneficial because you can earn interest on the money rather than give it to someone else to earn interest with.  If the loan interest rate is 4.95% and you can earn 5% or more in another investment, you are better off deferring the payment.  In the corporate world, if the interest rate is lower than the discount rate, or cost of capital, the loan with deferred payments is favorable.

Why Balloons Are Bad For Some People:  A 15% balloon on a $100,000 mortgage leads to a $15,000 payment at the end of the life of the loan.  If you are smart, you would stash away $42 per month in a high interest savings account (affiliate link) over 30 years to cover the balloon at the end.  Everyone is not that smart.

Some people spend that $42 every month and have no way to pay off the loan at the end.  This is poor planning, and is not the bank’s fault.  It is the fault of the person who signed papers for a loan they could not handle.

How To Make Balloons Work For You: If you can’t earn more in interest than your loan interest rate, it is in your best interest to pre-pay everything as fast as you can.  If you can do better elsewhere, such as the stock market or bond investments, it is best to delay payments as long as possible.  Just be sure to save every month so you can pay it at the end.

Ever had a baloon loan or know someone with a good story?  Please share in the comments.

Long before I had this blog, I had a car loan.  My old car, a hand-me-down 1990 Volvo Station-wagon with about 200,000 miles, decided to stop working while driving west on Belleview Avenue one summer morning.  Fixing it would have cost as much as the car was worth, so I decided to get a brand new one.

After all, I had a good job and was living at home with my parents.  It seemed like a good idea.  Now, two and a half years later, it still seems like it was a good idea.  I still love the car and I was able to pay off the loan two and a half years early.  That is half of the scheduled time for those of you who are math impaired.

Over the lift of the loan, I paid a total of $675.53 in interest to the credit union for my $10,995 loan.  That is not too bad.  I like to think of that $675 as my car rental fee for the roughly 30 months I have been using the car so far.  That is a savings of $573 from the total interest if I had only made minimum payments.

I took a screen shot to commemorate my last online payment.  Silly me, I didn’t check the “payoff amount” and was left with four cents that I could not pay online.  A quick phone call took care of that though.

I plan to keep this car for many, many years and I am glad I have it.

What am I going to do with all of the money I had been putting into the loan?  I am sticking to my own advice.  My debt snowball leads me to student loans from here.  I have just about $21,900 left there.  I am still in school, so most of the loans are not accruing interest for another 7 months.  I have paid about $20,000 into my student loans while I have been in school, so paying down the rest shouldn’t take more than another two or three years.

Do you have any good loan payoff stories?  Please share in the comments.

If you have taken out loans to go to school, you most likely have Federal Stafford loans from at least one bank.  If you ended up with more than one bank, you have to make two sets of payments every month for those loans.

I have two sets of loans, and in about 7 months they will come due.  When that happens, I will probably find a consolidation loan.  There are a few important things to know about consolidation loans if you are planning to consolidate.

First, do not get the impression that a consolidation loan will save you money.  Federal Stafford loans, the most popular type of student loans, are fixed at 6.8% by the government.  If you have two loans with minimum payments of $100 each and you consolidate, you will just have one payment of $200.

If you do not get the same kind of loan when you consolidate, the process can actually cost you more money.  Make sure that if you have student loans to consolidate you continue with a Federally backed loan with the same fixed interest rate.

Consolidation can also impact your credit score.  The impact should not be big depending on when you got the first loan.  When you consolidate, you close two loans with history and replace them with one brand new loan.  This lowers your average account age and can impact your credit.

I have had some Peer to Peer lending excitement that I thought I would share.  I have had both a scare and an early payment, but it seems that all is doing well in Eric’s Lending Land.

First, I will share the scare and how it was resolved.  I first noticed something was wrong one day when I logged in at LendingClub and saw that one of my loans was in the 31-120 day late bucket.  The loan had a partial payment and missed payment.  I was not sure if I would be out the $25 or if it would work out.  This is the collection log as of today:

You can see where the trouble begins, on 11/6, with a failed payment.  Since then, Lending Club worked dilligently to bring the loan current.  It took a few months, but things have smoothed out.  I also got a $.09 late fee for my portion of the loan. (Click to enlarge)

I have also now had two loans payoff in full.  That means I lose out on interest but get my entire outstanding principle back early.  I can re-loan the outstanding principle into a new loan, and plan to do so shortly.  My account balance today, including the outstanding loan, is $53.92.  That is roughly a 7% annual return.  Not bad at all.

Since last writing about Lending Club, I have become an affiliate.  That means, if I refer you to sign up, you get $25 to start with and I get a little bonus in my Lending Club account.  I promise that if you sign up, I will keep the cash in Lending Club and will keep you updated on the progress.

What do you have to lose?  It takes five minutes and you get $25 bucks for free.  I think an hourly rate of $300 is not too shabby.  To sign up, follow this link to Lending Club for $25 free. (If you sign up, please also let me know in a comment or through the contact form.  Thanks)

If you are a fan of peer to peer lending, you might be interested in microfinance.  Microfinance is a type of lending designed to help people in poor communities around the world start a small scale business that can completely change their standard of living.

Muhammad Yunus, a banker from Bangladesh, is often credited with bringing microfinance to the mainstream.  His principle is that people in poor communities might only need a small loan to start a profitable business model.  Remember that currencies, exchange rates, and standards of living are completely different in rural Africa and Southeast Asia.  There, $25 or $100 might be all that is needed to change the outlook for an entire family.

Microfinance lenders are small banks accessible by people living in rural areas.  The banks will generally lend money to a community of people, rather than an individual.  Experience has shown that communities are generally very honest when working together, and default rates are much lower.  Remember, rural Africans do not have bank accounts or credit scores, and their economies are generally sustenance based.

Microfinance banks, for the most part, take out large loans from major commercial banks.  While on a trip to New York over the summer, I met the microfinance team for Deutsche Bank.  These lenders do due diligence on the lenders around the world, and give them large sums to lend out in the form of microloans.

While this growing system, which has proven both challenging, risky, and profitable, is able to reach people all over the world, there are still financing shortages.  That is where you can come in.

One major project, called Kiva, is a peer to peer lending facilitator for microloans.  Kiva describes itself as a service that helps you lend to low income entrepreneurs.  You can learn more at about it at Kiva.org.

I like several things about microloans through Kiva.  First off, it is like a charity, though it is not a donation.  When you loan money to someone, you can plan to get that money back with interest.  In $25 increments, you can change the lives of family or village somewhere in a developing part of the world.

Lending through Kiva is not risk free.  There is a good chance that these people, living with no financial infrastructure, will not pay the loan back.  However, most do.  The people receiving microloans are generally honest people with a sense of responsibility to pay the loan back.  Kiva facilitates the payment through one of a number of microlenders, and those lenders are responsible for collecting the loan payments and ensuring the transaction is equitable for all parties.

Kiva also allows you to give gifts to friend through loans.  You can give a friend a gift at Kiva that they choose how to distribute.  The goal is, in a few years, that they get the gift money back with interest.  It is not too late for a Chanukah or Christmas gift through Kiva.

The site has been endorsed by political leaders and business people around the world, though it has been criticized for its high loan rates.  Kiva argues that those rates are high because it is important for the banks to offset the high default rate for these types of loans.  Kiva takes funds through a no fee PayPal transaction.

What do you think of Kiva?  Have you tried it?  Have you heard about it?  Please share in the comments.

Anyone who has ever had a loan has seen the statements that come updating you on your progress.  Early on, it is often disheartening to see that the bulk of your payment went to just the interest, and a small amount went to the outstanding loan balance.  If you ever wondered why and how it works, read on.  If not, read on anyway, you could still learn something.

When someone gets a new loan, there are several important factors that determine the amortization schedule, or schedule of payments including interest and principal reduction.  Those inputs are: loan length in years, number of payments per year, interest rate, beginning balance, and ending balance.  In most cases, the ending balance is zero and 12 payments are made per year.  Based on these factors, a loan amortization schedule can be created.

There are two ways to create a loan amortization schedule.  First is the nerdy finance academic way, which sucks.  I promise, I have done it before.  It is a stupid waste of time.  The second is with a computer, that way takes about five seconds.

Based on the inputs above, the loan amortization calculator will determine what monthly payment is needed for the loan to have the desired ending balance given the interest rate, starting balance, and terms of the loan.  The loan is broken up in such a way that you can see what interest is required and what principal balance remaining would be after each period.  An easy calculator that gives an annual amortization can be found here.  This is a sample amortization for a 30 year fixed mortgage on a $250,000 house at 6%.  Notice that in the first year, only $500 goes to the principal, while the rest goes to interest.  Because interest only accrues on outstanding principal, interest decreases every year.

Now is the good part.  If you pay extra into the loan in a period, that extra amount directly reduces the principal.  All of those times I have written about the benefits of early payments can be clearly seen when using an amortization schedule.  Fortunately, Microsoft Excel has a great loan template that allows you to include extra payments.

If you understand how loan amortization works, you understand about 90% of important financial concepts.  Bonds, loans, and anything with an interest rate uses the same set of formulas to calculate present and future values.  Did I confuse you?  Feel free to ask questions in the comments.

[SPONSORED POST]

I recently watched my student loan climb for the fourth of five (I cut one off!) times during my MBA program.  It is a little disheartening and overwhelming to see my Stafford Loan balances climb.  My total student loan debt today is $15,981.  However, had I not been paying the loans aggressively while in school, my loans would total well over $27,000.

The average student today is leaving school with some form of debt.  In the US, about two thirds of undergraduates leave college with debt.  The average senior has $23,186 excluding federal PLUS loans at graduation.  Masters degree students tack on an additional $25,000 in student debt on average.  Looking for a PhD?  Expect another $52,000.

At 6.8% (the federal student loan rate) over 10 years, the average student loan payments from grad school alone is $287 per month.  If you are just rolling over the average undergrad and graduate student loans into one monthly payment, plan on $554 per month.  I hope you get a good job if you are in that situation.

Student loan debt is a growing problem in the US and around the world.  Fortunately for grads with large debt, most lenders will allow for deferred payments and graduated payments if you are struggling.  You just need to ask.  However, people are not planning ahead when they are taking on student debt.  It might be easier now to take an extra $6000 per year to help with school, but is it better in the long run?

Many students would have lived a less lavish lifestyle in college had they realized what their student loans were going to do.  It is almost as bad for students with credit card debt, though the upcoming law changes will end most of that.

I know a lot of the readers of this blog are either in school or are recent graduates.  How are you all dealing with student loan debt?  Are you paying the minimum?  Are you paying more?  Are you struggling to just keep the loan current?  Let us know in the comments, maybe a few of us have some ideas for how to deal with it.

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Home Equity Ad from Community Bank Delaware

If you pick up the Wall Street Journal on any particular day, you might find an article that mentions HELOCs.  You probably see that word on a poster or rate board at your local bank as well.  You might get something in the mail (or e-mail) from your credit union advertising the best HELOC rates around.  That is all great if you know what a HELOC is.  Consider this post HELOCs for dummies.

HELOC stands for Home Equity Line of Credit.  HELOCs are a form of home equity loan.  Since I have never discussed home equity loans before on this site, I figure we can knock out two birds with one stone.  So sit back, relax, kick your shoes off, and get ready for a short lesson on real estate loans.

First off, you need to own a home and have equity to qualify for any home equity loan, as the name implies.  Home equity is the ownership you have built up in your home.  To calculate your equity, subtract your outstanding loan principal from the present value of your home.  If your home is appraised to be worth $250,000 and you have $100,000 left on a mortgage, you have equity of $150,000.  Equity changes based on those two inputs.  If the value of your property goes up or down, as constantly happens due to market conditions, your equity will change.  If you pay down your mortgage loan, you will also impact your equity.

So, in the example above you have equity of $150,000.  If you need a lot of money for a planned purchase, such as a car or large home improvement, you can take out an installment loan based on that equity.  The rate of a home equity loan is generally the lowest interest rate a consumer can find.  However, it also means that if you stop paying, the bank can foreclose on your house.  If you plan on paying every month (as we all do), you can get a better “car loan” rate if you use a home equity loan instead.

Sometimes, however, emergencies come up.  We don’t all have an emergency fund, even though we probably all should.  For these scenarios, HELOCs come in handy.  A HELOC is a line of credit attached to your property.  Like all lines of credit, your HELOC works kind of like a secured credit card with unique fees.

If you decide you want a HELOC, you will have to pay fees up front to create the loan.  Once it is established, you never have to use it.  If you don’t use it, you don’t have to pay any more.  If you do use it, you have to pay interest on the outstanding balance, like a credit card, and pay back the loan balance at a later date.  Some HELOCs simply accrue interest and require no payment until the end date of the loan.  Some require interest only until the loan end date.  Others institute a minimum payment based on the outstanding balance.  You can generally negotiate this with the bank when you set up the loan.

If my opinion, HELOCs are a good idea for established homeowners for emergency use.  If you are new in real estate, this is just another complicated loan that lets you spend money you will eventually have to pay back.  If you have a lot of equity and want to be ready for when the water heater breaks, you need to replace the furnace, or a plumbing emergency comes up, a HELOC might be right for you.  Just remember, it can take weeks to setup this type of loan.  If you want it in an emergency, waiting for the pipe to break will be too late.

If you think I missed anything or have any questions, feel free to say so in the comments.

I am sure you realize that the bank pays you for keeping deposits there.  Many young people do not have loans, so they have never thought out the process of banks making money.  Why should they even care about keeping you as a customer?  Here is how banks make money and a few ideas on making money in the same way.

To get the first questions out of the way, banks make a ton of money from different types of fees.  NSF (overdraft) fees, low balance fees, transfer fees, wire fees, origination fees, and anything else that ends in “fee” is a hugely profitable area for most banks.  NSF fees are one of the top money makers for the industry.  Out of network ATM fees are pretty nice for them as well.  Don’t pay them, negotiate them away or avoid them by knowing how your bank works.

Now, for the traditional bank money making technique.  Banks borrow money at a lower rate than they lend it to someone else.  I think it is a fairly simple process.  Here is an example:  Bank borrows $1,000 (from five people’s deposits) for 1% interest per year.  Another customer decides to buy a $5,000 car and needs a loan.  The bank loans that person the money at 6%.  That gives the bank a 5% margin (6%-1%), or $250, in profit.

Banks do that a lot.  That is the scale of “it takes money to make money.”  If the bank has 1,000,000 customers with $1,000 and loans out 80% (assuming a 20% reserve requirement), they can earn $40 million in profit with a 5% spread.  Even if 5% of the loan go bad, they still earn massive profits.  The currently subsiding financial crisis was contributed to by a high number of loans becoming delinquent and forcing the banks to take large losses.

So, how can you make money like a bank?  How can you borrow money at a low rate and loan it out at a higher rate?  There are several options.  Those include private loans, P2P lending, and gaming the no interest introductory rate system.

Private Loans:  These are a good idea for wealthy individuals who have a high tolerance for risk.  You can make an under-the-table loan to anyone with any terms that you see fit.  Make sure to get a legal contract in writing so you can enforce your side, even for friends and family.  There is a big risk that they may stop paying and you can’t do anything about it.

P2P Lending:  I am a big fan of P2P lending if you have the right fit.  P2P (Peer to Peer) lending cuts out the bank.  You give the money, generally in $25 increments, to someone who needs a loan.  You get the payments back for your share of the loan along with all interest.  P2P lending facilitators, such as Lending Club and Prosper, take a small cut for being the middle man for the loan.  If you diversify and loan money across many people, you are lowering your total portfolio risk.  Lending Club has a detailed prospectus if you are interested.

Gaming the System:  This takes a lot of time and effort, but you can make a little extra cash from gaming zero interest periods from credit cards and loan.  Beware, however, that opening and closing credit cards has a big impact on your credit score.  How does it work?  If you see an introductory rate credit card with no interest and no fees, you can withdraw your entire credit line (hurts your credit score also) using a credit line check (sometimes has fees) and put the money into a high interest savings account or CD.  Because you pay no interest, you keep the entire profit of the interest you earn from the CD or savings account.  If you invest in other, higher returning places, such as stocks, you risk losing the initial investment and having to pay back the credit card loan at a loss or paying interest.  I don’t recommend this, but some people do.

In all, it is tough to be the bank.  The old adage “it takes money to make money” is true.  There are big risks in playing banker, but there are big yields if it is done right.  But if mafia loan sharks can do it, you can too.  Just make sure things are legal, clean, and you are aware of any potential losses.

Have any of you tried these, or other, methods to earn interest from loans or the borrow/loan spread?  Please let us know in the comments.

I just got a letter in the mail from my student loan company saying that my loan has been sold to the US government and will now be processed by a federal payment processing center.  This is common in the student loan and mortgage loan business.  I figure that if it is happening to me, it is happening to other people to.  And if a bank does it, it is probably confusing.  Here is how it works.

If you have a student loan like I do, you make a regularly scheduled payment to the issuing bank.  When dispersed, the loan company paid my school on my behalf.  The money is already out the door, and my payments are reimbursing the bank for the payment plus interest.

The money the bank lent out was from other customer’s savings accounts and certificates of deposit.  If the accounts are not touched for a long time, that is great for the bank.  They pay 1% interest to the customer and loan the funds out at 7% (example).  That is a 6% earnings while the money is there.  However, if a lot of customers want their savings back, the bank has to give it to them.  If the money is all loaned out, they need to either borrow from other banks or sell assets.

The primary asset of banks are loans.  It is an asset because it is money that they are expecting in the future.  They can sell a group of loans together to another bank, or the government, for a slight discount.  If they have $10,000,000 in loans outstanding, the other bank might pay $9,500,000 for title to the loans.  That will ensure the bank is protected from potential losses on future loans.

That all sounds complicated, but for you it is not.  Here is how simple it is for you: you just make your payments to someone else.  That’s it.

Any questions?  Anything I missed?  Let me know in the comments.