Make sure you understand how the cost of your loan is determined.
Personal loans can be a great option if you need to borrow money. That’s because they tend to have affordable interest rates, and you can use the money from them for just about any purpose.
But before getting a personal loan, it is a good idea to understand exactly how much the loan will cost you. After all, you will end up paying a lender for the loan, so you need to make sure that you are comfortable with the full amount it will cost you in the end. There are actually three different factors that will affect the cost of the loan, and it helps to understand all three to make sure a personal loan is right for you.
This is what they are.
1. The interest rate on loans
Interest is the cost of borrowing, expressed as a percentage of the loan amount. For example, if you borrow at 10% interest, each year you will pay the bank 10% of the value of the loan. A high interest rate means that your personal loan will be much more expensive than if you qualify for a low rate loan. For example, a $ 10,000 personal loan repaid over five years at 10% interest would cost you $ 212.47 per month and the total interest costs would be $ 2,748.23 over the life of the loan. In contrast, the same loan at a 25% interest rate would come with a monthly payment of $ 293.51 and the total interest costs over time would be $ 7,610.79.
Interest can vary considerably between lenders, so get multiple quotes to find the best and most affordable rate. Your credit score can also influence the amount of interest you end up paying. So it’s a good idea to make sure that’s in order before applying for a personal loan because, as you can see, personal loan interest rates make a big difference to your costs.
2. The amount you are borrowing
Since interest is equal to a percentage of your loan amount, borrowing more means your interest costs will be much higher. Since you have to pay both principal and interest, a higher loan balance will also mean much higher monthly payments.
Considering the example above, let’s say you borrowed $ 20,000 for five years at 10% interest instead of borrowing $ 10,000 for the same time. Your payment in this case is doubled. Instead of paying $ 212.47 a month, you are now paying $ 424.94 and the total interest costs increase from $ 2,748.23 to $ 5,496.45.
That is why you should make sure you borrow enough to meet your needs and try not to borrow more than is absolutely necessary.
3. The repayment schedule
Finally, the time it takes you to pay off your loan balance in full will also determine both your monthly payments and your total costs. You may have the option to extend your payment schedule for a really long period. That makes your loan seem more affordable because you would be reducing your monthly payment amount. But when you take this approach and agree to pay interest for many, many years, you end up paying a lot more in the end.
Again, let’s take the example above of borrowing $ 10,000 at 10% interest, but this time let’s say you’re paying off your loan in 10 years instead of five years. While your monthly payment drops to $ 132.15, your total interest costs over time are $ 5,858.09. Ultimately, you need to carefully consider each of these three criteria. If you want to keep loan costs low, try choosing a loan with a low interest rate, as well as the lowest possible loan balance and the shortest repayment term you can afford.
For more information, our guide on how personal loans work has more information to help you decide if a personal loan is right for you.