When taking out a loan, whether big or small, always do your homework beforehand. The more you’re knowledgeable about the cost of borrowing before entering into a financial transaction, the better.
The concept of borrowing money is pretty straightforward: take out a loan first, then repay it. However, the cost of it is more than what you borrow. It doesn’t only include your loan amount but also interest rates, terms, and other fees. Let’s check them out here.
Loan Amount
The loan amount refers to the total funds you borrow from a lender, excluding the other upfront loan fees.
It can likely affect the terms available, interest rate, and possible fees you must pay over the life of a loan. Since it may influence other borrowing costs, it’s recommended to determine the amount you need in advance. However, avoid overextending yourself and borrow what you need only.
The higher the loan amount, the longer it’ll be paid off, which means more interest rate.
Interest
The interest rate on a loan is one of the indispensable costs of borrowing money. Many thought of it as the fee lenders charge you for borrowing money. For many lenders, it’s compensation to them for bearing the risk of financing you.
Simple Interest
Lenders generally charge what’s known as “simple interest,” which results from multiplying these factors: principal x rate x time. For example, let’s say you take out a loan with a principal of $2,500 at 5% for one year.
You’ll calculate it as $2,500 (principal) x .05 (rate) x 1 (time). Note that the time here should be the number of days borrowed divided by 365 (the number of days in a year). The result will be $125, which is now your simple interest. If you add this interest to your principal ($2,500), you must repay $2,625.00.
Compounding Interest
Some lenders allow adding interest to the principal balance, which is called “compounding interest.” For example, many private lenders allow students to delay their repayment until their graduation. Although their loan repayments are on hold, the interest still accrues and will be compounded to their loan’s principal balance.
Lenders compound accrued interest monthly, quarterly, semiannually, or annually. Regardless of this, most financial advisors recommend paying the accrued interest first before adding it to the loan’s outstanding balance to save more money.
Let’s say you have a four-year loan for $2,500 with an interest rate of 5%. If you let your lender add accrued interest yearly over four years, you’ll likely have $538.78 compounded to your loan’s balance by the time you start repaying.
In other words, the more frequently lenders compound interest to the principal loan balance, the higher the interest borrowers will pay. To avoid this, opt for lenders who don’t compound interests or do it infrequently, usually close when the loan repayment schedule starts.
APR (Annual Percentage Rate)
Federal law requires lenders to follow the Truth in Lending Act, which requires lenders to disclose a loan’s annual percentage rate (APR) to borrowers. It’s a broader measure of the cost of borrowing expressed as a yearly rate or percentage.
APR is a more reasonable indicator of the cost of your loan. While it may not always include all charges on a loan, it’s generally composed of the interest plus other loan fees, including discount points, origination charges, and agency fees paid to the lenders.
As such, it’s recommended to focus on the APR instead of the interest rate when comparing rates from various lenders, who may all have different fee structures. Additionally, opt for a lower APR.
Other Fees
As mentioned, an APR reveals most costs involved in a loan. However, it may include everything, so better research them in advance since they can increase your pay. Remember, the more additional fees, the higher the cost of borrowing.
Here are the most common fees to be aware of:
- Loan application/origination fees – payment for loan application processing and underwriting services
- Late payment fees – cover any costs lenders incur to collect late payments
- Prepayment penalties – charged if a loan is paid off ahead of schedule
- Annual fees – cover the costs of servicing a loan
- Transfer fees – the fee for transferring a balance from one credit account to another
Loan Term
The loan term also called the “repayment period,” refers to the length of a loan. More specifically, it’s the length of time you have to completely pay your Cost of Borrowing off if you make the required minimum monthly or regularly scheduled payments.
Most common borrowing options include a term. Its length, whether short-term or long-term, can influence the total amount of interest and monthly payment you’ll pay over the life of the loan.
The general idea is that shorter terms have higher monthly payments, while longer terms have higher costs. However, the meaning of “loan term” may still vary from lender to lender and depending on the loan type, so it’s better to ask the lender to clarify.
Final Thoughts
Don’t let financial jargons get in the way of obtaining your ideal loan. These terms are only used to address the overarching aspects of a complex loan process. If this article isn’t enough and you’re still confused, don’t hesitate to contact a professional.