What affects the cost of a loan?

The cost of the loan is the main thing everyone pays attention to when borrowing money. Yet, the majority mistakenly assumes that the cost of the loan equals the interest rate. It turns out that the total (the final) cost of a loan is comprised of several elements along with the interest rate.

Each element (described below) could be lowered by a lender in the interest of a borrower if latter matches needed requirement.

When you shop around for better terms for your mortgage, or a car loan, keep in mind that initially you’ll be offered a certain % that does not define the final loan’s cost. Nevertheless, you can always make terms more beneficial by opting another length of the loan or providing a bank with valuable collateral or involving a co-signer with higher credit score than yours.

Anyway, don’t get mislead about the cost of the loan you are offered just by comparing interest rates. Send lenders an inquiry for an APR to have a full picture.

Interest Rate

Interest rate is a basic factor that determines the overall cost of a loan. Interest rate means how much every 100 dollars of the loans cost for a borrower. For example for the loan of 1000 dollars with the interest rate 7%, the cost of the loans is 70 dollars.

Interest Rate

Short-term loans have usually lower interest rate than long-term ones. Still, long-term loans will cost you more after all even with the lower interest rate (you will have to make more payments on 30-years mortgage than on a 15-years home loan).

Besides, an interest rate can be fixed or variable (totally up to a borrower which one to choose). It’s important to determine what is better for you before signing an Agreement: a fixed interest rate means you will pay the same price for using a loan during the whole loan’s term.

Variable interest rate means it can be increased or reduced depending on the pool of factors. Fixed interest rate gives stability, variable interest rate gives a fair price that follows economic conditions, inflation, and so on.

What factors influence interest rate?

When offering you a certain interest rate, lenders take into consideration several factors, such as:

  • the credit score of a borrower: the lower the score the higher the interest rate, as lender assume they take higher risks so they include the cost of the increased risk into the interest rate. Usually, credit score above 630 is considered as excellent one, so a borrower gets the best interest rate.

credit score

  • the overall state of the economy at the current moment, as the stronger the economy the higher the interest rate. Lenders assume people have enough income to get more loans for buying expensive things like property, cars, etc. Therefore, borrowers are able and willing to pay a higher interest rate for a loan.
  • the fact whether a borrower has collateral influences interest rate the most. Unsecured loans are the most expensive ones, while collateral is a guarantee for a lender that he will not lose their money even if a borrower will fail to repay the loan.
  • the fact of a bankruptcy in the past, even in the credit score of a borrower is fully restored after he went bankrupt. Lenders have full access to bankruptcy records during 10 years after the debtor’s filing.

Breaking down the APR

APR stands for the Annual Percentage Rate which is the real and final cost of the loan that includes an interest rate plus all the fees that a borrower pays for using a loan.

Annual Percentage Rate

Types of fees depend on the type of a loan, so the most common fees included in Annual Percentage Rate are:

  • Origination fee that is taken for a new account opening, it varies depending on the lender. Usually, origination fee is 1% of the loan’s sum
  • Prepaid interest or loan points. Loan points mostly relate to mortgage loans and are paid by a borrower in order to have his interest rate slightly reduced;
  • Legal fees for closing a loan (ask your lender for exact sum of the fee).

There are special APR online calculators on the Web to help you determine the Annual Percentage Rate.

Penalties

The cost of a loan could be increased due to some penalties a borrower pays in certain circumstances.

Penalties

The most common penalty is charged for premature loan’s repayment. It may sound non-reasonable, given that bank should be happy about the money returned, but don’t forget that lender earns on your monthly interest rate payment and by paying the loan off prematurely you terminate this source of income to a bank.

There could also be penalties for monthly payments delay, although some lenders allow a certain period of delay without charging a borrower for it.

Credit score/credit history

credit history

It stands to reason that the more extensive your credit history and the higher the credit score the lower the cost of the loan you will be offered. It is excellent if your credit score is higher than 600, it says to a lender you are solvent, reliable borrower so risks for lenders are minimal. Your credit score is built not only from your returned loans but also from timely paid utility bills, Insurance premiums and other payments on your financial obligations.

Credit history shows a lender how many times you took and returned loans so he can evaluate the chances of his money paid back by you. The more returned loans in your history the cheaper your next loan will be.