Comparing the Cost of Loans: Term, Interest Rate & APR

Series: General Concepts

Page 1 of 2

Comparing the Cost of Loans Terms of Use:

There are three things to look at when you take out a loan. Each one affects how much you pay for the loan:

  1. The length or term of the loan

  2. The interest rate

  3. The annual percentage rate

LENGTH OF THE LOAN

The length of the loan is the easiest part to understand. The shorter the length of the loan, the quicker you’ll pay it off, and the less interest you will be charged. However, the shorter the term, the bigger your payments.

Here’s an example of monthly payments on a loan for $5,000 at 5% interest:

Term

# of Payments

Payment Amount

Total Interest

5 years

60

$94.36

$661.60

3 years

36

$149.85

$394.76

1 year

12

$428.04

$136.45

INTEREST RATE ON THE LOAN

Lenders charge you a certain percent of the amount you are borrowing every year. This is the annual interest rate, sometimes referred to as the nominal interest rate. This rate is used when calculating the interest expense on your loan.

Let’s check how different interest rates affect the price of a five-year, $5,000 loan, again expressed in monthly payments:

Int Rate

# of Pymts

Pymt Amount

Total Interest

3%

60

$89.84

$390.61

5%

60

$94.36

$661.60

10%

60

$106.24

$1274.11

Using financial calculators, you can plug in different interest rates and different lengths and see what happens to each payment and the total cost of the loan.

ANNUAL PERCENTAGE RATE

You’ve looked at both your interest rate and the length of the loan. Now you need to add up all the finance charges and other fees that the lender may demand.

Assuming you are not a math genius, how do you compare a $5,000 loan at 5% interest over five years with a $400 origination fee, with a $5,000 loan at 4% over three years with an annual fee of $30 and an origination fees of $85?

Until 1974, it was just about impossible to compare them. In that year, however, Congress passed the Consumer Credit Protection Act.

Series: General Concepts

Page 2 of 2

Comparing the Cost of Loans Terms of Use:

Also referred to as the Truth-in-Lending Act, the Consumer Credit Protection Act included the government’s standards for annual percentage rate calculations. Ever since then, all lenders are required by law to tell you their annual percentage rate as well as their nominal interest rate so that you can better compare one loan to another.

It’s best to think of the APR (annual percentage rate) as the all-inclusive rate on a loan. In addition to the stated interest rate on your loan, it includes how fees, points and closing costs affect the interest rate.

The annual percentage rate is figured like this: You add up the interest for one year and every finance charge. With some loans, especially home mortgages, there can be ten or twenty kinds of fees like appraisal, credit report, processing, origination, etc.

Let’s look at our $5,000, five-year loan at 5% interest, but this time we’ll add a $100 processing fee. We are now borrowing $5,100.

Our monthly payment goes up to $96.24 (instead of $94.36 shown in the first table), and our total interest becomes $774.60 (not $661.60). The APR is 5.819%.

Loan Amt

Fees

Term (yrs)

Int. Rate

Total Int.

APR

$5100

$100

5

5%

$774.60

5.819%

$5000

$400

5

5%

$1114.28

8.218%

$5000

$115

3

4%

$436.55

5.515%

To compare APRs on the other two examples: a $5,000 loan at 5% interest over five years with a $400 origination fee has an APR of 8.218% (total interest of $1,114.28).

The other $5,000 loan at 4% over three years with a processing fee of $30 and an origination fees of $85 has only $436.55 total interest and an APR of 5.515%. In this case, the APR tells the story.

The government wanted APRs to provide a way of comparing loans, but APRs are not perfect. In comparing APRs from different lenders, the biggest challenge is in understanding the lender’s use of actual or estimated closing costs included in the APR calculation.

With “balloon payment” loans, for example, you pay so much a month for so many years, and then a big payment is due.

Credit card loans can be hard to compare because of things like penalty fees, interest rates that can change, and other factors.

With mortgages, fees like escrow, notary, attorney, home inspection and many others are NOT included in the APR.

See what you learned.

Check out "Verrry Interesting"and "The Lowdown on Loans"

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KBID: 1785Date Modified: 3/1/2011Date Created: 10/8/2009

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