What is the cost of borrowing money?
Have you ever bought concert tickets, only to realize when confirming your final total that the price of being a Swiftie is far greater than you expected? Sure, the seats themselves only cost $75 each, but then there are order processing fees, delivery fees (even when you’re using a digital ticket, which seems unfair), facility charges, and the always-fun taxes for the perfect finishing touch. It’s enough to make you want to sing the entire “Red” album at home in your PJs instead (almost).
Taking out a loan can feel very similar. You want to borrow $1,000. Your lender says there’s a straight borrowing fee or a simple interest rate, like 10%. Seems simple enough, right?
But the reality is that borrowing money is rarely as simple or straightforward as we expect. Here’s a look at the true cost of borrowing money, plus some info about how you can protect yourself when you need a loan.
What is the cost of borrowing money?
It’s crucial to understand the total cost of borrowing money before you take out a loan because there’s a good chance your expectations and the reality are not quite on the same level. That’s not your fault. Many lenders make bank (pun intended) by tacking on tons of fees that are not clearly listed. You’d have to be a financial whiz kid or bank insider to know that you’re on the hook for fees you didn’t even know existed.
Of course, not all banks are the same. There are banks like Varo that believe in transparency, offering customers a clear, easy-to-understand contract that includes no hidden fees, lots of cash back options, and early access to their own money.¹ Still, it’s not always feasible to use one financial institution for your bank account and also for your borrowing needs.
So, let’s learn about the total cost of a loan and how you can spot potential problems before they hit your wallet.
The loan amount—AKA, the “principal”
The primary cost of your loan will be the initial loan amount, also known as the principal. This is the chunk of money you’re asking to borrow. Need $15,000 to buy a used car? That $15,000 is your principal. Buying a home with a $30,000 down payment and a $345,000 mortgage? That $345,000 is the principal on your home loan.
This concept is fairly clear-cut, but there’s a second consideration to keep in mind. Most of the fees that we’re about to dig into—interest rate, fees, extra costs—hinge on the principal. That means that the higher your principal loan amount is, the more you’ll likely pay in associated fees. The best way you can mitigate your costs and avoid unintentionally amplifying the total cost of borrowing money is to only borrow what you need.
Just because a lender approves you for a huge amount of money doesn’t mean you have to take it all. Borrow only what you absolutely need for the exact purpose you originally intended to use the money for. Having extra “just in case” may sound nice, but it’s likely to hurt your bottom line in the long run.
The interest rate or APR
Many lenders charge simple interest. This is a nice approach because it involves one easy-to-understand calculation:
principal x rate x time = interest
But it’s important to know some other things about interest and how rates are determined, too.
Your interest rate is the amount you pay to a lender—on top of your principal—for the privilege of borrowing money. Interest rates can fluctuate wildly based on everything from the condition of the market to your own credit score. If you’re taking out a mortgage, your interest rate could change depending on the location of your property, too.
Your interest rate affects your monthly payment, as minimum monthly payments typically include a portion of the principal as well as a chunk of the interest. There are exceptions, however, such as an interest-only mortgage. Still, the vast majority of the time, a lower interest rate means a lower monthly payment.
Annual percentage rate (APR) is a little different. APR is a more “big picture” cost of borrowing money. It’s shared as a yearly percentage and includes the interest rate, other fees, and discount points.
Fixed rate vs. variable rate
As mentioned above, interest rates don’t exist in a vacuum. How your interest rate is initially determined, how often it fluctuates, and how big those fluctuations are ultimately all depend on which type of loan you take out.
Fixed-rate loans don’t change. As the name suggests, the interest rates on these loans are fixed. That means you’ll always make the same monthly payment (unless you volunteer to pay extra), and if you stick to that schedule, you’ll pay off your loan at the end of the term laid out during the initial borrow.
Variable-rate loans are subject to change in relation to factors like market rates and financial trustworthiness. For instance, if the federal funds rate changes, your interest rate may change too. It’s common to sign a loan with a variable-interest rate that locks in a certain interest rate for a specific amount of time, but when that time frame is up, your rates are likely to change.
The rate you choose should reflect the market and your personal circumstances. Fixed rates may be technically safer and more predictable, but you could end up paying a not-so-awesome rate for a long period of time with little hope of an out. With a variable rate, you could score with an appealing interest rate now and then get nailed with a soaring rate if the market or your credit score changes, leaving you unable to meet your obligations later on.
The term of your loan
In financial speak (seriously, shouldn’t all this stuff come with a free interpreter or something?), a loan term is the amount of time it will take you to settle your loan. This calculation assumes you’re only making the minimum monthly payments required by your lender.
The longer the term of your loan, the lower your monthly payment will be. The flip side of those lower payments is that a longer loan term means more money out the door in interest and fees over the total lifespan of the loan.
Here’s what a $300,000 loan at a fixed 8.00% APR might look like over the course of three different loan terms:
Total payments: $436,779.34
Total interest: $136,779.34
Total payments: $602,236.85
Total interest: $302,236.85
Total payments: $792,465.74
Total interest: $492,465.74
With those numbers, it’s easy to see how a lower monthly payment thanks to a longer loan term can cost exponentially more money in total. The difference in costs between a 10-year and 30-year term adds up to over $350,000. Assuming the initial $300,000 loan was for a house, the person who signed up for a 30-year term could have bought a second house for all the fees they forked over.
Of course, it’s not always practical to go for the short loan term. The 10-year term has a monthly minimum payment that’s over $1,400 more than the 30-year term’s monthly payment. That chunk of change could be used to pay other bills. You could put it into investments, or you could blow it on avocado toast. The point is this: everything is a tradeoff.
One plan of attack is to take the longer-term loan but pay extra toward the principal whenever you can. You’ll pay your loan off sooner than expected and save on the associated interest.
Just like TicketBros and Concerts R Us charge up the wazoo for silly extras that have little to do with buying an actual event ticket, lenders can (and often do) tack on additional fees that increase the cost of borrowing.
Origination fees: Think of origination fees as the “cost of doing business” added on by your lender. You’re paying for the company to process the loan application, and some of those fees will probably go to underwriting services as well.
Transfer fees: It would be nice if it was free to transfer your money from institution to institution, but it rarely is. Transfer fees cover the cost of wiring or otherwise sending your money when it’s time to accept the loan or repay as directed.
Annual fees: Some lenders also charge borrowers an annual fee. They may put these fees toward administrative costs.
Late charges: Send your monthly minimum payment late and you may be hit with a late charge. These fees may be percentage based, such as 3.00% or 5.00% of your loan balance. Or they may be assessed as a flat fee, such as $35 tacked onto your monthly payment. Either way, late charge policy details should be laid out in your original contract. Also, the lender has the right to report payments 30-days (or more) past due to the credit bureaus.
Prepayment penalty: Unfortunately, it’s not always advantageous to pay off your loan early. Some lenders rely on the income attached to interest and fees, and they’re calculating that income based on the assumption that you’ll take the entire loan term to complete repayment. Therefore, there could be a prepayment penalty for settling your loan early. Sometimes, though, the penalty is still less than you might pay by merely sticking to the minimum payments for the full loan term, so make sure to do your own calculations and weigh the pros and cons of prepayment.
Some fees must be paid up front. Others are attached to the loan and rolled into your monthly payments. Also note that not all lenders incorporate every one of these fees. Shop around until you find the lender and loan terms that feel right for you and your financial situation. Think of it like a relationship—if they’re just telling you what you want to hear, it’s probably too good to be true.
You can also avoid some fees by setting up autopay. Ask about automatic payment agreements when applying for your loan, and you’ll lower the risk of nonpayment and perhaps even see lower loan fees as a result.
When it comes to taking out a loan, not all institutions play by the same rules. At Varo, transparency is the name of the game. We believe in being fair and up-front with our terms. That’s why we offer Varo Advance, a cash advance based on direct deposit amounts.² No interest, one simple fee, and the money is yours.
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