by Christy Bieber | June 7, 2021
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Make sure you understand how the cost of your loan is determined.
Personal loans can be a great option if you need to borrow cash. That's because they tend to come with affordable interest rates, and you can use the money from them for virtually any purpose.
But before you take out a personal loan, it's a good idea to understand exactly how much your borrowing will cost you. After all, you will end up paying a lender for the loan, so you want to be sure you're comfortable with the total amount it will cost you in the end.
There are actually three different factors that will affect the cost to borrow, and it's helpful to understand all three of them to make sure a personal loan is right for you.
Here's what they are.
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Interest is the cost of borrowing, expressed as a percentage of the amount of the loan. For example, if you borrow at 10% interest, then each year you'd pay 10% of the loan's value to the bank.
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A high interest rate means your personal loan is going to be much more expensive than if you qualify for a loan at a low rate. For example, a $10,000 personal loan repaid over five years at 10% interest would cost you $212.47 per month and total interest costs would be $2,748.23 over the life of the loan. By contrast, the same loan at a 25% interest rate would come with a monthly payment of $293.51 and total interest costs over time would be $7,610.79.
Interest can vary considerably between lenders, so get multiple quotes to find the best and most affordable rate. Your credit score can also play a role in how much interest you end up paying. So it's a good idea to make sure that's in order before you apply for a personal loan because as you can see, personal loan interest rates make a huge difference in your costs.
For more information on your credit score and why it matters, check out the following guides:
Since interest equals a percentage of your loan amount, borrowing more means your interest costs will be much higher. Since you have to repay both principal and interest, a higher loan balance will also mean much higher monthly payments.
Keeping the above example in mind, let's say you borrowed $20,000 over five years at 10% interest instead of borrowing $10,000 over the same time. Your payment in this case doubles. Instead of paying $212.47 a month, you're now paying $424.94, and total interest costs jump from $2,748.23 to $5,496.45.
That's why you should make certain to borrow just enough to cover your needs and try not to borrow more than is absolutely necessary.
Finally, the time it takes you to fully repay your loan balance will also determine both monthly payments and total costs.
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You may have the option to stretch out your payoff timeline over a really long period. That makes your loan seem more affordable because you would be reducing your monthly payment amount. But when you take this approach and agree to pay interest for many, many years, then you end up paying a lot more in the end.
Again, let's take the above example of borrowing $10,000 at 10% interest, but this time let's assume you're repaying your loan over 10 years instead of over five years. While your monthly payment goes down to $132.15, your total interest costs over time go up to $5,858.09.
Ultimately, you need to carefully consider each of these three criteria. If you want to keep the costs of borrowing down, try to choose a loan with a low interest rate, as well as a loan balance that is as low as possible and with the shortest repayment timeline you can afford.
To learn more, our guide on how personal loans work has more information to help you decide whether a personal loan is right for you.
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