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.
|Total Interest Paid
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
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
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.
|Total Interest Paid
|Total Cost of Loan
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.