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Comparing the cost of borrowing

Lesson in Course: Investing basics (advanced, 5min)

We're taking out a loan, but how can we tell if the terms are right for us?

Eureka!

What it's about: Amortization schedules show us the total interest we'll pay and the monthly payment.

Why it's important: We can compare which loan is more expensive and which will fit our budget better.

Key takeaway: Balance paying the lowest amount of interest with monthly payments that we can afford.

It is always a good idea to shop around before making any major purchases. The same is true for when we are planning on borrowing. Let’s say we are looking to buy a car. There are a lot of banks and other lending institutions out there that might offer us different loan terms; how do we compare and decide which one is right for us?

Loan terms and total interest

Since interest is the cost of borrowing, one way of comparing different loans is based on the total interest paid over the life of the loan. However, the total interest depends on the terms of the loan. 

Interest Rate

While it might be obvious that higher interest rates result in paying more interest over the life of the loan, remember that interest rates are reflective of risk. Lenders like banks are concerned about default risk so they rely on credit scores to help determine our creditworthiness.

What is Default risk?

The risk that a borrower won't be able to make the loan payments on time or in full

Borrowers with lower credit scores are considered less likely to repay the debt. So, lenders want more interest (a higher return) if they're going to risk their money.

 

Maturity Date

The maturity of the loan also carries a level of risk. Loans that take longer to pay back are inherently riskier and therefore will typically have higher interest rates. The more time until maturity means that there is greater uncertainty about what will happen between now and then. The potential for both positive and negative outcomes is higher.

Even though the total amount of interest is greater, a loan with a longer maturity usually has lower monthly payments, assuming the loans have the same principal. 

 

Comparing loans

The best way to compare loans is by looking at the amortization schedules. They provide us with the monthly payments and total interest, the information we need.

What is Amortization schedule?

A table that lists each payment and how the balances change over time. It also shows how much of each payment goes toward paying interest and principal.

When we check out the examples for buying a car and a house below. We'll want to focus on the total interest and monthly payments when looking at the two loans in each example. We'll find that there is a tradeoff between the cost of the loan (total interest) and the monthly payments. Longer loans have lower payments but cost us more.

We'll also notice that the cost difference between car loans is much smaller and might not be enough to sway us one way or another. On the other hand, huge loans with longer maturities like mortgages can have life-changing cost differences of over $100,000!

Buying a car

Suppose we're buying a car and we've been approved to borrow $20,000. The length of car loans is usually between 2 and 8 years. 

Let's say the 3yr/36-month loan has an interest rate of 4%. Here is an amortization schedule that shows the first and last 5 monthly payments. 

Loan 1: $20,000 3yr/36-month at 4% interest

Paying almost $600 per month might be too steep, so let's check out what happens when we extend the maturity to 6yrs/72-months. We know that loans with longer maturities will have higher interest rates, unfortunately. So let's be a little more realistic and assume the interest rate is bumped up to 5%.

Loan 2: $20,000 6yr/72-month at 5% interest

Now that we have both amortization schedules, let's compare Loans 1 and 2:

Loan 1: 

  • Costs less - paid $1,257.27 in interest and $21,257.27 total for the car
  • Higher monthly payments ($590.48)
  • Paid off sooner (3yrs/36-months)

Loan 2:

  • Costs more - paid $3,191.10 in interest and $23,191.10 total for the car
  • Lower monthly payments ($322.10)
  • Paid off later (6yrs/72-months)
Buying a house

Suppose we're buying a house and we've been approved to borrow $300,000. The length of most mortgages is usually either 15 or 30 years. 

Let's say the 15yr/180-month mortgage has an interest rate of 3%. Here is an amortization schedule that shows the first and last 5 monthly payments. 

Loan 1: $300,000 15yr/180-month at 3% interest

Paying more than $2,000 per month might be too steep (this also isn't including any of the additional costs that are usually wrapped in with mortgage payments), so let's check out what happens when we extend the maturity to 30yrs/360-months. We know that loans with longer maturities will have higher interest rates, so let's be a little more realistic and assume the interest rate is bumped up to 4%.

Loan 2: $300,000 30yr/360-month at 4% interest

Now that we have both amortization schedules, let's compare Loans 1 and 2:

Loan 1: 

  • Costs less - paid $72,914.09 in interest and $372,914.09 total for the house
  • Higher monthly payments ($2,071.74)
  • Paid off sooner (15yrs/180-months)

Loan 2:

  • Costs more - paid $215,608.52 in interest and $515,608.52 total for the house
  • Lower monthly payments ($1,432.25)
  • Paid off later (30yrs/360-months)

Actionable ideas

Do your best to be a credit-worthy borrower. You'll qualify for the lowest interest rates if you have a high credit score.

Ideally, you want to lower interest as much as possible as a borrower but think about what your cash flow needs are. There is a balancing act between making the payments large enough to reduce the total interest paid but still having enough cash flow to make those payments comfortably. Keep in mind that you’ll have to be able to make the payments through the good times and the bad.

Supplementary Materials

Credit score ranges
Check out this helpful amortization calculator

This free amortization calculator shows monthly payments, as well as a schedule, graph, and pie chart breakdown of an amortized loan.

https://www.calculator.net/amortization-calculator.html

Glossary

What is Default risk?

The risk that a borrower won't be able to make the loan payments on time or in full

What is Amortization schedule?

A table that lists each payment and how the balances change over time. It also shows how much of each payment goes toward paying interest and principal.