What is the first thing you think about when someone mentions borrowing money? For many people, it is rates and terms. They think about the going interest rate and how much their monthly payments will be. But how many of us stop to think about how rates and terms affect the total amount spent to repay a loan?
If you are among those consumers who look at borrowing only in terms of monthly payments, perhaps you are not giving consideration to what is known as the ‘cost of borrowing’. Salt Lake City’s Actium Partners explains it as paying for the privilege to borrow. You pay for it through interest, fees, and charges. By far, interest accounts for most of the total cost of borrowing. Second only to interest are the terms of a given loan.
Interest and APR
It is important to understand the difference between interest rate and APR. They are not the same. An interest rate is a percentage of what you are charged for the privilege of borrowing. For example, if you borrow $100 at 1% for 12 months, your interest would be $1. We arrive at that number by multiplying 100 x 0.01 (1%).
Annual percentage rate combines interest and all the other charges and fees you pay to borrow. This is necessary because most loans include the charges and fees in them. So perhaps you buy a house. There may be a title transfer fee of several hundred dollars involved. That fee is rolled into your mortgage. It is combined with interest and all the other fees and charges to determine your annual percentage rate (APR).
The last thing to note is that the APR is what you pay every year, based on what you still owe. Using our previous example, let us say you borrow $100 at 1% annually but only repay $10 per year. Your first year, the rate would be calculated based on $100. The second year, it would be based on $90 and so on. That means you are essentially paying a new interest ‘bill’ every year.
How Terms Apply
A loan’s terms determine how many payments you will make and how frequently you will make them. A typical mortgage has a term of 30 years with payments made every month. Every payment you make is divided between principal, interest, and the fees and charges.
Here is where the total cost of borrowing comes into play. If you extend a mortgage for the full 30 years, you pay an awful lot of interest. If you borrow $100,000 at 4% for 30 years, your total interest payments would amount to more than $162,500. Reduce the same mortgage to 20 years and your total interest drops to just over $45,400. Reducing the term by one-third cuts interest by more than half.
This is one of the reasons investors are not afraid to use hard money loans from Actium Partners. Hard money loans may have higher interest rates, but they also tend to have terms of no more than one or two years. Investors do pay more interest per year. But because they pay their loans off so quickly, the total amount of interest they pay is substantially less in real dollars.
What is the lesson here? Whenever you are borrowing money, do your best to keep the terms as short as possible. The longer the term, the more total interest you will pay. A short-term with a low interest rate is ideal. But even with a higher interest rate, the shortest possible term saves you the most money in the long run.