by Christy Bieber | Updated July 21, 2021 - First published on Nov. 22, 2019
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When you're taking out a loan, this mistake could cost you a fortune.
Lenders offering personal loans, car loans, and other types of financing often stress how low the monthly payment could be. In fact, it's common to see advertising for a new car, furniture, or other big-ticket item at very low monthly prices.
Borrowers are encouraged to look at the monthly payment for one simple reason: It can hide how expensive the loan can actually be.
That's because monthly payments can be made lower by stretching the repayment period over a long time. When this happens, though, interest costs can add up quickly -- especially on higher-interest debt.
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A focus on monthly payments can get you into trouble with any kind of debt, whether it's a mortgage, car loan, personal loan, or even a credit card. In fact, if you have a credit card with a minimum monthly payment equal to a small percentage of what you owe, it's easy to think that it's affordable because it's "only $50 or $60 a month."
While you do need to make sure you can afford the monthly payment on any loan you take out to avoid late payments and potential default, it is just as important to understand the total cost of the loan. A loan may seem like it's a good deal if the monthly payment is small, but if it's only low because you've stretched out repayment for a decade, the debt is usually one to be avoided.
To avoid a myopic focus on monthly costs that could lead to expensive borrowing mistakes, be sure to read all loan terms carefully. Look at the interest rate and repayment timeline and find out the total you'll pay over the life of the loan when deciding whether to borrow and which lender to borrow from.
To better understand the downsides of only focusing on monthly payments, consider two different options for a $5,000 personal loan at a 7% interest rate. With one lender, you'll pay off the loan over three years and with the other you'll repay the loan over seven years.
The first loan with the three year repayment timeline would have a monthly payment of $154 per month and you'd pay a total of $558 in interest over the life of the loan. The second loan, however, would have a monthly payment of just $75, so it might seem much more affordable. However, the total cost of the interest would rise to $1,339 because you're paying interest for so much longer.
The loan with the lower monthly payment would cost you over $780 more and you'd be tying up $75 a month for an extra four years. You'd also lose out on the opportunity to do other things with that money, such as save for your future or use it to cover expenses so you can more easily live within your means.
Looking at all loan terms is important when borrowing. If your goal is to pay the least amount of interest and get the lowest borrowing costs possible, always choose the loan with the shortest repayment term -- as long as the payments remain affordable.
Alternatively, if you'd prefer more flexibility, you could choose a loan with a longer repayment period and make extra payments when you're able -- as long as you're disciplined enough to actually send that extra money in.
Whatever option you choose, just be sure you understand that monthly payment alone isn't all that matters. Don't be enticed by a loan that's more expensive just because its low monthly payment makes it seem cheaper at first glance. Find out the total loan cost and make an informed decision.
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