When you apply for a loan from a licensed money lender the amount you need to pay is not just the proceeds you received. You will have to factor in the interest rate for the loan. Planning out a loan and how you will repay the loan should go hand in hand. Otherwise, the amount might surprise you later on.
This is especially true for first-time borrowers. If you are one, it may seem shocking and even unfair. After all, you are applying for a loan because you are short on money. Why would you agree to pay more than what you borrowed?
However, you need to consider that interest rate is part of the reasons why they lend money in the first place. Running a business entails many costs, and lending money is a high-risk business venture. As a business, lenders will need to mitigate this risk by charging interest and penalties.
What Affects Interest Rate?
Interest is not just something they pull out of thin air. In general, it is affected by the law of supply and demand. If many people are borrowing money and the demand for loans is high, the interest rate would also be high. Here are the other factors affecting interest rates:
Inflation rate
When the inflation rate is high, the value of money decreases. This is why you can afford to buy more items with $100 a few years ago compared to today. The effect of this is that lenders will also charge higher interest rates to compensate for the decrease in the value of money.
Type of loan availed
If you are availing of a personal loan which has no collateral involved, expect that the interest rate would be higher than if you are availing of a mortgage. The difference is that, if there is collateral which the lender can foreclose in case you fail to pay, the risk involved on their part will decrease.
Your Credit Score
If you have a good credit score and your borrowing record is pristine, chances are, you can avail of favorable and lower interest rates.
In fact, if you have proven to be a good payer in the past, you might be able to negotiate the interest rate. This is again due to the perceived lower risk involved in the transaction. Transacting with a borrower who has been known for paying loan obligations on time is less risky than with a borrower who has failed to pay obligations in the past.
The Term of Your Loan
Since the risk of non-payment increases with the length of the period for payment of the loan, interest rates are generally higher for long-term loans. Lenders want to balance out the uncertainty and risks. They also consider that you might be in a better financial position now than in the future, hence, they will charge higher interest rates to cover the risks involved.
Other Things You Need to Know About Interest
While it will not be possible to be financially savvy or to master the intricacies of interest computation overnight, here are some basic considerations you have to know and keep in mind:
Interest rates are either Simple or Compound
A simple interest rate is the principal amount multiplied by the rate and the term of the loan.
On the other hand, a compound interest rate is a bit more complicated. It is calculated by multiplying the principal amount by one plus the annual interest rate raised to the number of years interest is applied, minus the principal.
Make sure to discuss with your lender what type of interest applies to your loan. Take the time to calculate the costs. Ask questions and clarifications so that everything, especially the computation, will be clear to you.
2. Grace Period
Many factors affect one’s capacity to pay. It is best to plan for the worst-case scenario while you’re still not there. Ask your lender upfront what will happen in case you fail to pay your amortization for a few days or months. Negotiate for a reasonable grace period so you will have room to fulfill your obligation.
3. Annual Percentage Rate (APR)
The APR includes the interest rate on the principal amount of your loan, and fees such as points and origination fees. These terms might seem highly technical, which is why you should take the time to ask your lender to explain it to you in simple terms. Keep in mind that since lending is a business, whatever costs that the lender will encounter in the transaction will probably be transferred to you in one way or another. It’s best to be informed.
Conclusion
While it’s natural to gloss over complex ideas especially those that may involve complicated math and financial computations, keep in mind that these factors can affect your loan and your capacity to pay. It would be best to have a basic understanding of the interest rate of your loan so you can strategically plan how you can repay it.
Do not hesitate to ask upfront for all the penalties and charges that the lender might put on your bill. Have it explained to you in simple terms before you sign any loan agreement.
