Work out what a loan really costs, so you can compare offers on the total amount repayable and not only the monthly payment.
When you borrow, you pay back more than you receive. The difference is the cost of credit, and it is made up of interest and fees. Knowing how to work it out helps you compare offers and avoid surprises.
Key terms
Principal. The amount you borrow.
Interest. The price of borrowing, usually shown as a percentage of the amount borrowed for each year.
Fees and charges. Extra costs such as processing fees, insurance, account charges and penalties for late payment.
Term. How long you have to repay the loan.
Total amount repayable. Everything you will pay over the life of the loan, including the principal, interest and fees.
Flat rate and reducing balance
Lenders calculate interest in different ways. With a flat rate, interest is worked out on the full amount borrowed for the whole term, even as you pay it back. With a reducing balance, interest is charged only on what you still owe, so it falls as you repay. Two loans with the same headline rate can cost very different amounts depending on the method. Always ask which one applies.
An illustrative comparison
The figures below are made up to show how the calculation works. They are not real offers.
Loan A
- Amount borrowed: D20,000
- Repayments: D2,000 a month for 12 months, which is D24,000
- Processing fee: D500
- Total amount repayable: D24,500
- Cost of credit: D4,500
Loan B
- Amount borrowed: D20,000
- Repayments: D1,450 a month for 18 months, which is D26,100
- Processing fee: D300
- Total amount repayable: D26,400
- Cost of credit: D6,400
Loan B has the lower monthly payment and the smaller fee, so it may look cheaper at first. In fact it costs D1,900 more overall and keeps you in debt for six months longer. A lower monthly payment often means a higher total cost.
The right choice depends on what you can comfortably afford each month. If you can manage the higher payment of Loan A, you pay less in total. If you cannot, a longer loan may be safer, but you should know what it costs.
Watch for extra costs
- Late payment charges, which can build up quickly
- Fees for changing the loan or repaying it early
- Insurance or account charges that come with the loan
- Charges for going overdrawn without an agreed limit
How to compare offers
- Ask each lender for the total amount repayable, in writing.
- Ask for the annual interest rate and how it is calculated.
- List every fee and when it is charged.
- Compare the total cost, not only the monthly payment.
- Check that the monthly payment fits your budget with room to spare.
If any figure is unclear, ask the bank to explain it before you sign.