Of course, you know what it is to borrow money. Sometimes we even need money today. And, of course, you are very familiar with loans. It isn’t easy to find an adult who has never borrowed money. You may have even read the loan agreement carefully. But do you know what the real cost of a loan is?
How to calculate the real cost of a loan?
The present value of the loan consists of:
• Principal (total loan amount that you borrowed),
• Interest rate,
Together it all comes in APR – annual percentage rate. And it’s the true cost of borrowing money.
So let’s take a look a bit closer.
The principal amount is the amount that you get on your bank account when you take a loan, or the value of the goods (for example, a house) for which you take a loan.
Interest rate is the so-called payment for using money. Accrued interest can be fixed rate or variable rate.
• A fixed interest rate means that you will pay the same amount of interest throughout the time.
• A variable interest rate means the rate may change depending on what the big banks will publish interest rates.
But that’s not all about interest rates. They could be simple and compound.
• A simple interest rate is easy enough to calculate. Multiply the daily interest rate by the principal amount and the number of days between payments. To calculate the simple rate, use the formula: principal X interest rate X time.
Suppose you took out a mortgage worth $300,000 at 4% for 30 years. So your simple interest rate will be calculated like this.
$300,000 X 4% X 30 = $360,000
So you will pay $360,000 in total interest.
• Compounding interest is calculated not only based on the principal balance but also based on interest that has been accumulated in previous periods. Interest can be added to the loan’s lump sum on a monthly, quarterly, semiannual, or annual basis. The rate at which compound interest accrues depends on the frequency of compounding.
The higher the number of compounding periods, the greater the compound interest. The formula for calculating compound interest is: x = P (1+r/n)nt – P. There are X for interest rate, P is for principal amount, r is for annual interest rate, n is for the number of compounding periods and t is for time for which you borrow money.
The same mortgage we calculated earlier will be much more expensive – you will pay about $700,000 in total interest. It makes the total cost of borrowing money extremely high, and it will cost you far more in the long run.
So let’s make it more clear. Fixed interest rates are more profitable than variable rates because you always know what to prepare for. Simple interest rates are way cheaper than compounding interest. And it’s easy to calculate.
There is more than one type of additional fee. At least we have origination fees and late fees that the bank or lender charges.
Origination fee. When the lender deducts the processing fee from the total amount, it’s called the origination fee. It can be from 1% to 5%, or it can be a fixed amount. You will still pay the total amount, including origination fees. But there is a way to avoid this kind of fee. Usually, if you have a good credit history, banks or lenders do not require an origination fee.
Late fee. It will be a problem if you are late with your monthly payments. And late payment fees will be an additional problem. So to save money, you need to read payment terms carefully and stick to them.
Sometimes, banks or lenders provide a grace period. It lasts from one to five days by the due date of the monthly payment.
Another essential component of the true cost of borrowing money is the loan term. The longer the loan term, the lower the monthly payments. But at the same time, the cost of borrowing will be higher because you will pay more interest.
The faster you can pay off the loan, the cheaper it will cost. But pay attention to whether your loan provides for an early payoff penalty.
Early payoff penalty
A lender or a bank charges an early payoff, which is also called a prepayment penalty. Lenders expect to get your money by charged interest. And when you decide to pay off your debt earlier, they want interest rates to be paid anyway. Most often, there are three ways to accrue early payoff.
You will have to pay the remaining interest or a percentage of your balance. Sometimes there is a fixed rate that you will have to pay in case of early repayment of the loan. And this is another point that can be added to the total cost of borrowing money.
What is the true cost of the loan: which one is better?
To date, the number of loan offers is simply huge. There are financial products for every taste: short term loans and long time loans, secured and unsecured, and many other loans. Let’s compare some of them, their annual percentage rates, and check what their payment includes.
Secured or unsecured loan?
It is generally accepted that secured loans are cheaper because of lower interest rates. But there is a nuance. The main difference lies in the type of loan.
Personal loans are usually unsecured. But suppose you have a good credit score. In that case, you can get a very profitable proposition with a lower interest rate than some secured loans offer.
At the same time, home equity loans, as secured ones, can be more advantageous than payday loans, which are unsecured.
A secured and unsecured loan can cost you a lot of money. The cost of borrowing will depend on your credit score and loan term. Usually, a shorter loan term costs more because of the higher rate. Their annual percentage rate will be higher as well.
Which type of loan is more advantageous for borrowing money?
Everything depends on your credit score and the term you need to pay back your debt. Borrowers should not send their loan applications to just one bank. It would be better if you choose several ways to borrow money.
A personal line of credit
It can be a good choice if you find a bank that will provide you with an introductory period. Furthermore, a credit card is a very convenient option. You don’t need to pay interest rates from 15 to 21 months in this period. But watch your balance, and don’t pay only the minimum payment. Otherwise, you will be dragged into a debt hole. Nevertheless, a credit card has an acceptable cost of borrowing.
Home equity loan
Maybe it’s the best way to borrow money if you need a large amount. Usually, interest rates are pretty low, about 5%-6%, and the repayment period is 5-15 years. It costs an average amount compared with other deals. But make sure you can afford all payments and not risk losing your house.
This is a generic way to borrow money. You can borrow from $1,000 to $50,000, choose different terms and look for better conditions, especially with a good credit score. If you pay your monthly payments on time, everything will be okay.
What additional costs need to be paid by borrowers?
In addition to the principal amount, the borrower will pay interest rates and origination fees when they repay a loan.
What type of borrowing is the most/the least expensive?
The most expensive is a payday loan. For example, if you get it, your fees may be from $15 to $30 per each $100 borrowed. The least expensive borrowing is usually a personal loan or home equity loan. Still, it all depends on the borrower’s credit score.
How can I repay borrowed funds?
You can pay your monthly payments on time or pay back your debt earlier. But be careful of prepayment penalties.
Is borrowing money a good idea?
Yes, if you are ready to pay on time.