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Cost of Credit

Just as you compare prices and options when shopping for a car, it is important to comparison shop for a loan. Along with the various types of loans available, each lender offers different terms, rates, and fees that affect the cost of the loan. The amount of interest you pay depends on three things; the amount borrowed, the interest rate, and the term or length of the loan.

Interest Rates

Interest Rates

One of the most important factors to consider when selecting a loan is the interest rate. Interest is the price you pay for the privilege of borrowing money.

To aid comparison-shopping and eliminate hidden costs, lenders are required to specify the interest rate as an annual percentage rate (APR). The APR includes the interest rate plus all fees and costs, expressed on an annual basis. Choosing a loan with a lower APR will save you money.

An APR may be fixed or variable:

  • A fixed APR  is a specified percentage rate that does not change during the life of the loan. Most vehicle loans and mortgages have a fixed APR.
  • A variable APR  is usually specified as a certain percentage over a moving index, such as the Wall Street Journal Prime Rate. Some credit cards, home equity loans/lines of credit, and mortgages have a variable APR. Monthly payments on variable rate loans can fluctuate, so it is important to understand the loan agreement when considering this type of loan.

To demonstrate how the interest rate affects the cost of a loan, let's look at an example.

Samuel is purchasing a car from an auto dealership for $23,000. He has a down payment of $3,000, so he needs to borrow $20,000. The dealership will finance the car at an APR of 12 percent. Samuel's bank will finance the car at an APR of 8 percent. Let's calculate the cost of the loan and the monthly payments.

 
  Example 1 Example 2
Loan Amount $20,000 $20,000
Term 5 years 5 years
Interest Rate 8% 12%
Monthly Payment $405 $445
Total Interest Paid $4,331 $6,693

As you can see, the interest rate affects the amount of the monthly payment and the total amount of interest paid over the life of the loan. That's why comparison shopping is important.  

Loan Term

Loan Term

The term is the amount of time allowed to repay the loan. Monthly payments, including principal and interest, are predetermined at a set amount to extinguish the debt by the end of the term. Most lenders allow you to pay off the loan early without penalty.

Although a longer term means lower payments, it also means you will pay more interest over the life of the loan. While affordable payments are an important consideration when selecting a loan term, other factors to consider are the total amount of interest paid, how long you will keep the financed item, and its value at the end of the term.

To demonstrate how the term affects the cost of a loan, let's look at an example.

Hannah is shopping for a new car. She has $2,000 for a down payment and wants to keep her monthly payments under $500. Hannah compares loan amounts and terms on the chart below.

  Example 1 Example 2 Example 3
Loan Amount $30,000 $30,000 $20,000
Term 5 years 7 years 5 years
Rate 8% 8% 8%
Monthly Payment $608 $468 $406
Total Interest Paid $6,498 $9,277 $4,332
Total Cost of Loan $36,498 $39,277 $24,332

The monthly payment on a $30,000 loan is within her budget only if she finances it for a seven-year term. Hannah opts for a more affordable car. She borrows $20,000 for a five year term, saving nearly $5,000 in interest over the life of the loan.  

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