Nov30

How to Determine the Cost of a Loan

In a perfect world, everyone would have the cash necessary to self-finance important purchases, and debt would be a thing of the past. Unfortunately, we live in the real world, where borrowing is often a necessary part of everyday financial life.

With that being the case, it’s important to understand as much about the borrowing process as possible, not only to avoid the inevitable credit damage from bad financial decisions, but to also avoid paying far more for financial products than you really should. This is especially important for borrowers with poor credit who are already looking at higher-than-average financing costs.

Indeed, with bad credit, it can be easy to fall into the trap of taking the first loan for which you’re approved. But the truth is the best personal loans for those with bad credit combine flexible credit requirements with reasonable loan terms, rather than simply dropping a big pile of fees into your lap. To really understand the cost of what you’re borrowing, however, you need to understand all the factors that contribute to the cost.

The Interest Rate is Only the Start

The first mistake many people make when shopping for loans is focusing solely on the interest rates they’re offered. While the interest rate you’re charged is obviously important for any credit product, getting hung up on the APR and ignoring other loan factors can be a mistake when comparing loans.

It all comes down to how your interest fees are calculated for loan products. The interest fees you pay for revolving credit lines, including the range of credit cards for bad credit, depend primarily on your APR and average daily balance. When it comes to loans, however, it’s a slightly different story.

That’s not to say your loan’s interest rate isn’t important; it most certainly is important. But for loans, the amount of interest you pay will be impacted just as much, if not more so, by the length of your loan as it is by the APR you’re charged, because loan interest is typically compounded monthly. So, to calculate your monthly payment and total loan cost, you’ll need to incorporate your APR, principal amount, and how long you need to repay your loan.

As an example, consider a hypothetical borrower, Betsy, who is looking at a $10,000 loan with a 15% interest rate that she’ll need 36 months to repay. By putting those numbers into an online loan calculator, Betsy can determine that her monthly payments will be around $347 each month. She can also see that she’ll need to repay a total of $12,450, meaning her loan will cost her around $2,480 in interest fees.

To crunch the numbers by hand, you’ll need to create what is known as an amortization table. Amortization tables show every monthly payment, including how much of that payment goes toward the principal versus the interest, and the size of the remaining principal balance.

Amortization tables are helpful for loan cost calculations since most loans use monthly compounding interest, which calculates your monthly interest fees based on your remaining principal at the end of the previous month. In other words, as you pay down your balance, the amount of your monthly payment that goes toward interest decreases, instead going toward your principal.

For example, in Betsy’s case, $222 of the first $347 monthly payment she makes will go toward her principal, while $125 of the payment will go toward interest. After making her first payment, her principal will thus decrease by $222, to $9,778. The next month, the amount of interest she is charged will be based on the remaining balance of $9,778, so her interest charge for the second month will decrease to $122.

Depending on the length of your loan, building an amortization table by hand can be a long process. Many online loan calculators will do the math for you, making it simple to determine the cost of your loan. Spreadsheets can also be a helpful tool (if a touch archaic these days) for creating amortization tables without needing to use excessive math.

Loans Are More Expensive

Regardless of which method you use to calculate your costs, be sure to do it with each loan you need to compare, as even small changes can make a big difference. For instance, another side effect of the way loan fees are calculated is that you can generally lower your monthly payment simply by extending the length of your loan.

Returning to Betsy, her $10,000 loan will have a monthly payment of $347 if she takes 36 months to pay it off. If she extends her loan to 60 months, however, her monthly payment will decrease to $238 a month. Of course, that’s not to say that extending your loan is a good idea. The longer you take to pay off your debt, the more it will cost you overall.

For Betsy, extending her loan may appear to save her a little over $100 a month, but it actually costs her significantly more money over the life of the loan. To start, the monthly payments may be smaller, but she’ll need to make 24 additional monthly payments in the 60-month plan. She’ll also pay much more in interest. A 36-month loan would cost Betsy $2,480 in interest fees, while a 60-month loan will be nearly double that at $4,274 in total interest.

All in all, the cost of your loan will depend on each individual factor, including your principal, APR, and loan length. Changing any factor can impact how much you pay to borrow, so consider each factor carefully when comparing personal loans, particularly loans for bad credit, where every penny can count.

<em>Ashley Dull is the Finance Editor at Digital Brands, Inc., where she oversees content published on CardRates.com and BadCredit.org. Ashley works closely with experts and industry leaders in every sector of finance to develop authoritative guides, news and advice articles with regards to audience interest.</em>

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