Posted by Mike Smith :: August 6, 2007 @ 8:07 am

In the course of writing my recent post on how Lending Club rates are comparable with HELOC, an interesting point came up. I noticed when I was calculating the reduction of interest payments that if you could lower your rate by 1.25%, the starting interest rate factored into the savings as well.

At first glance, you might think that reducing your interest rate by 1.25% APR on a $25,000 loan with a three-year term would save you $937.50 ($25,000 x 1.25% per year x 3 years), regardless of your interest rate. That assumption would only be correct if you weren’t required to make monthly payments, but rather you could pay off the loan with one payment at the end of three years.

As a result of this discovery, I decided to calculate how much is saved in interest payments when you reduce your interest rate by varying amounts for different starting interest rates. The savings are given as a percentage of the principal. The following graph shows the results

(click graphic to enlarge)

Here’s how to read the graph: Let’s say that your bank offered you a HELOC at 11% and Lending Club offered you a loan at 8%. Your base interest rate would be 11%, and your reduction would be 3%, since 11%-8% is 3%. In that case, you would look at the yellow line (3% Reduction) and see that at a base rate of 11%, you would save about 5% of the principal in interest. So if you took out a loan for $25,000, you would save $1,250 (25,000 x 5%) in interest by borrowing from Lending Club at 8% versus from your bank at 11%.

The fact that all of the lines on the graph slope upwards, though some only slightly, shows that a reduced interest rate will save you more in interest payments for higher base interest rates. You will pay more interest at higher rates, but a reduction from 20% to 17% would save you more than a reduction from 11% to 8%.

Assumptions: Since P2P loans on Lending Club all have a 36-month term, that’s what was used for these calculations. This means that the savings are calculated as if the more expensive loan was also repaid in 3 years. If you took out a HELOC and repaid it over a longer period of time, a loan from Lending Club would save you even more than what is reported!

Background Calculations: The mathematics behind the calculations are beyond the scope of this post. For anyone interested in the details, I have posted them to a backup information page here.