KEY TAKEAWAYS
✔ “Cost of borrowing” refers to the total amount of money you will repay to a lender including the amount you borrowed (the principal), interest payments, and any fees.
✔ The cost will vary based on the type of loan, the interest rate, and whether or not fees apply.
✔ Amortization refers to the length of time that you’ve chosen to pay back the money you borrowed (the principal) plus interest. Generally, the longer the amortization, the higher the cost of borrowing.
Understanding the cost of borrowing will help you compare lending options with confidence. This will help you make an informed decision when it’s time to borrow for whatever you need.
The amount of money you borrow is not the same as the amount of money you pay back over time because lenders charge interest on the money they lend. Here are three factors that have the greatest impact on your overall cost of borrowing.
3 Factors affect the cost of borrowing
Types of loans and how much they cost
Loans fall into two basic categories: Secured and unsecured. A loan is considered “secured” when you offer the lender some kind of collateral (something that can be sold to pay off the loan if you can’t). For example, a car becomes collateral on a car loan. A home is used to secure a mortgage. All kinds of things can be used as collateral, including:
- Car
- Boat
- Home
- Stocks
- Bonds
- Insurance policy
An unsecured personal loan typically has a higher interest rate so if you have collateral, talk to your lender about using it to get a lower interest rate.
How interest rates affect the cost of borrowing
Interest is the amount of money you pay in addition to the principal amount you borrow. Getting the best interest rate based on your credit history and financial situation is the key to lowering your total cost of borrowing.
Interest rates are usually followed by the letters APR, which stands for annual percentage rate. Here are a few ways to qualify for a lower interest rate on your next loan.
- Collateral – using an asset to “secure” the loan.
- Credit rating – take steps to ensure your credit score is the best it can be.
- Loan insurance – purchasing loan insurance may result in lower interest and savings on the total cost of borrowing.
What is amortization and how does it affect the cost of borrowing?
The origin of amortization is rooted in the word, kill (mortem in Latin). It means to kill your debt. And who doesn’t want to kill debt?
But this five-syllable word also means, “time”. When you borrow money, you typically agree to pay it back over a specific number of months or years. For example, you can take out an unsecured loan from easyfinancial and pay it off fast over a few months, or take up to seven years.
Changing the amortization period of a loan has two immediate effects:
- A longer amortization results in lower monthly payments but a higher cost of borrowing over time.
- A shorter amortization results in higher monthly payments but a lower cost of borrowing.
Here’s how the cost of borrowing compares for the same loan amount (the principal) of $5000 at the same interest rate of 9.99% over three amortization periods – 12, 24 and 36 months.
|
Loan Interest |
Interest Rate |
Amortization |
Monthly Payment |
Total Cost of Borrowing |
|
$5000 |
9.99% |
12 months |
$439.35 |
$5,272 |
|
$5000 |
9.99% |
24 months |
$230.49 |
$5,532 |
|
$5000 |
9.99% |
36 months |
$161.00 |
$5,800 |
As you can see, taking more time to pay off a loan (longer amortization), will increase the cost of borrowing (principal plus interest) because the total cost of interest is higher. If you’d like to see a real world example of how the cost of borrowing works check out Isha’s story.
Before you borrow
How much you borrow, the type of loan you choose, the interest rate and the amortization period all affect your total cost of borrowing. Work with your lender to find the right combination to keep your borrowing costs as low as possible. It won’t take long to choose the right option for you. Speak with a loan specialist today and get approved in as little as 10 minutes.
Disclaimer: This content is intended for informational purposes only and does not constitute financial advice on any subject matter.
