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