How Much Do Loans Really Cost?

A loan is borrowed money. Ultimately, you have to pay it back, and usually, you pay more than you borrow. Consequently, the first consideration when borrowing should be:  do you have the capacity to repay? 

Borrowing money can feel like a pay day. It gives you the ability to make purchases that otherwise would have been unaffordable. It gives you more freedom as a consumer. However, you must make the mental shift that this is borrowed money, and repaying the lender in monthly payments is a priority. Otherwise, your credit score will take a serious hit. The lender may even hold the right to repossess your purchase if you are not following through with payments.

The 3 Main Factors Affecting How Much You Pay

The true cost of a loan is usually higher than the original amount borrowed (the principal). The true cost is attributed to three main factors:  the interest, the time period, and the amount of the loan.

The interest is the amount of money you pay to borrow money. It is a percentage, and the higher the percentage, the more interest you pay. The interest rate is often affected by your credit score. Typically, the better your credit score, the lower the rate, and contrarily, the worse your credit score, the higher the rate. Loans have a minimum interest rate, so even if your credit score is excellent, you still have to pay some interest.

Example

For a vehicle loan of $12,500 you may be able to qualify for 3.99% for 72 months. You can enter these numbers into a loan calculator to determine your monthly payments. 

If you know the loan amount, the interest rate, and the length of years, Use the loan calculator to determine the actual cost of your loan.

While you may not have much control over the amount of loan you borrow (depending on your negotiating skills, I suppose), you can ask to decrease the length of the loan. This would result in higher monthly payments, but a shorter repayment term would mean less interest paid over the long run. In addition, you can shop around to find superior interest rates, keeping in mind that your credit score may affect how low (or high) the final interest rate is.

Where To Shop

Comparing interest rates from various lenders can be done online. Credit unions and banks publish updates on their current interest rates on their websites. Still, with a variety of lenders - both traditional and non-traditional - it's hard to narrow down the search. Credit unions and banks, two common traditional lenders, can certainly loan you money for purchases. But how do you choose? 

A 2015 National Comparison of Average Savings, Deposits and Loan Rates at Credit Unions and Banks, can help narrow your search. The study indicates that credit unions are a great place to start. On average, credit unions have much lower rates on loans than banks, resulting in less interest paid, and more money in your pocket! 

                          Loan Type                                                              Credit Unions                        Banks     

Comparison of Average Savings, Deposits and Loan Rates at Credit Unions and Banks, June 26, 2015. Data source:  NCUA from SNL at www.snl.com

Comparison of Average Savings, Deposits and Loan Rates at Credit Unions and Banks, June 26, 2015. Data source:  NCUA from SNL at www.snl.com

Rule of Thumb

The rule of thumb for borrowing money is to never borrow more than you can afford to pay back. For student loans, plan to make as much (or more) than you borrowed in your first year's salary. For other loans, figure out your monthly budget. Write down all of monthly expenses. If another payment is going to cause you to owe more than you make, you may encounter some rough financial patches. So, never borrow more than you can afford to repay. 

Keep enjoying the Young & Free life! 

Mallory