If there’s one thing to be said about the modern world of consumer credit, it’s that the product options are abundant. While this is great for consumers looking for a good deal, sometimes there is such a thing as too many options (a dilemma quite familiar to anyone who has had the pleasure of waiting 15 minutes for the person ahead of them in line to order coffee).
Even something as seemingly simple as taking out a loan can turn into a series of decisions that require not only a bit of thought, but a bit of knowledge, as well. For instance, each type of loan, be it a mortgage, auto, student, or personal loan, has its own variations. Do you want a conventional mortgage or an FHA-backed loan? Should you get federally financed student loans, or private ones?
Beyond the peculiarities inherent in each type of loan, the majority of installment loans operate in the same general fashion, and each will be influenced by the same basic factors. Namely, your loan terms will primarily consist of your principal (how much you’re borrowing), the interest rate, often given as an annual percentage rate (APR), the loan length — how many months you’ll make payments — and the resulting monthly payment.
Two terms of your loan that it would behoove you to understand before you start shopping for your loan are your APR and loan length. Your interest fees and monthly payments are calculated based mainly on these factors, so your loan costs can change dramatically simply by varying these numbers. All in all, the key is to balance your rates, fees, and payments to ensure an affordable, cost-effective loan.
A Reasonable APR
The root of your interest fees, your interest rate is typically based on your individual credit profile, with influences, in lesser amounts, from the specific lender’s risk tolerance and, in the case of variable APRs, any changes in the US prime rate. In general, most credit products have a predetermined APR range, with the specific rate you receive dependent upon your creditworthiness.
Overall, secured loans tend to have lower APR ranges than unsecured products. This is why home mortgage loans have an average APR around 4%, while the average unsecured personal loan starts closer to 10%. For those with low credit scores, of course, you can expect to see rates higher than the average, while those with the worst credit may receive the maximum rate (or be turned down altogether).
In most cases, the only thing to be done about your APR (other than improving your credit score) is to shop around a few lenders, perhaps using an easy online lending network, to get an idea of the rates you can expect, then select a few of the lowest offers for further analysis of the other factors. Your interest rate can have a lot of influence on your payments, but, in most cases, it doesn’t do you much good to sacrifice more favorable terms, such as no prepayment penalties or an ideal loan length, simply for a few tenths of a percentage point of interest.
The exception is in cases where you need a specific interest rate to effectively consolidate or refinance your current debts. For example, some credit card loans to pay off debt will have lower interest rates than any of the cards you are looking to consolidate. If the credit card with the lowest interest rate charges 15%, you should look for a loan that has an interest rate of 14% or lower.
Furthermore, many great personal loans for people will still charge less interest than your average subprime credit card, so you may be able to find an effective APR.
The Right Loan Length
The length of your loan is perhaps even more impactful than your APR, particularly since the length of your loan can be varied so extensively as to alter your monthly payment by hundreds of dollars in either direction. How many months you spend repaying your loan will also be a major factor in how much total interest you pay over the life of your loan, essentially dictating how much your loan will end up costing you.
Imagine a hypothetical borrower, Erwin, who takes out a personal installment loan for $5,000 with an interest rate of 15%. If Erwin obtains a loan with a length of two years (24 months), he can expect to pay $242 a month, and a total of $818 in interest fees. If Erwin takes out a loan that is twice as long (48 months), his monthly payment will drop to $139, but he will end up paying a total of $1,679 in interest fees.
As the numbers show, if Erwin can afford to take on the monthly payments associated with the shorter loan, he’ll save over $800 in interest fees over the life of the loan. At the same time, if Erwin is likely to struggle to make the higher monthly payments, the extra interest fees can be worth paying to avoid the credit damage — and stress — of missed payments or default. The ideal loan terms balance an affordable monthly payment while minimizing interest fees.
Of course, you can only shorten your loan so much before the savings stop. Installment loans are designed to be long-term products, and they charge interest accordingly. Loans that extend less than six months are generally short-term loan products (also called payday loans or cash advances), which tend to have significantly higher interest rates than installment loans.
If you find yourself in need of short-term financing, you may be better off with a credit card than a loan. You can find some great credit cards on the web and compare offers for a reasonable rate. Since your interest fees will only increase over time, be sure to pay off your balance as soon as possible to avoid unnecessary costs.
Fees for Early Repayment
Regardless of the length of your loan, you can find ways to reduce the amount of interest you pay and decrease the total cost of your loan. One of the most effective methods is to overpay your loan, or to make multiple payments each month. This is because your loan payments generally go first toward your interest fees, then the remainder is applied to your principal.
By making larger payments during a billing cycle, more of your payment will go toward paying down your principal each month. Not only will this decrease the amount of interest you’ll pay each subsequent month since your interest payments are based on your balance, but it will also decrease the amount of time it takes to pay off your loan.
Whether you plan to make multiple loan payments or not, you should always investigate if it will cost you anything to pay off your loan early, just in case. Some loans will include a clause requiring an early repayment fee, which is charged when you pay off your loan balance before the time stipulated by your loan terms. Although perhaps not as influential as other factors on your decision to take out a loan, early repayment fees can be an inconvenient expense when all you want to do is finally enjoy a debt-free lifestyle.
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.