Lenders need to be aware of the costs. Loans can provide a lifeline for unexpected crises or help with upward mobility.
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Leslie Tayne is the founder and chief attorney of Tayne Law Group. She specializes in consumer debt. These loans can be used to pay for home improvements, unexpected expenses, and medical bills.
Matt Lattman is vice president of personal loans at Discover Loans. “The borrower receives a lump sum and then repays it through fixed monthly payments over a set repayment period. This makes it simple to budget and knows exactly when the loan will be paid,” says Lattman.
How personal loans work
Personal loans are typically unsecured. This means that you don’t have to provide collateral in order to obtain them. The lender will pay you a lump sum and you can use the money for many purposes.
Tayne explains that many personal loans have a fixed rate of interest and accrue simple interest. She explains that the interest you pay is based only on the principal, and not compounding interest which accrues additional interest.
An amortizing loan structure is one that reduces your owe over time. This ensures that your monthly payment is applied first to interest earned during the payment period, before it’s applied towards the principal. A majority of personal loans, as well as mortgages and car loans are amortizing loans.
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Lattman explains that amortizing personal loans means your monthly payment will be split between principal and interest. He explains that interest is usually accrued every day over the loan’s life. The daily interest charge will change when the principal balance is paid down. A higher percentage of your monthly payment may go towards interest fees at the beginning of the loan. The principal will be reduced by the majority of your monthly payments after the loan term ends.
Lattman explains that amortization is a mathematical problem. It involves figuring out how much principal you must pay each month to maintain your monthly payment amount, and making sure you have paid all of your loan repayments.
This is how the amortization process begins for the first few months. Below, you will see that almost all of the payments are going to interest and the final payment is principal.
Loans with Interest Only
You might be eligible for an interest-only loan in certain cases. Tayne explains that this type of loan allows you to only make interest payments. This can be a nice way to have some breathing space at first but it is easy to fall behind as your regular payments start. In some cases, the whole balance will need to be paid in one lump sum. This can be very difficult.
According to Lattman interest-only loans aren’t as common as personal loans and are more commonly used to finance a mortgage. Another common type of interest only loan is the interest-only HELOC.
Calculation of Loan Payments
The process of calculating your loan payment should be straightforward. The principal amount borrowed is divided by the term.
It gets complicated when you add in interest fees. Even though most people pay their interest monthly, it is expressed in an annual percentage rate (or APR). For example, if your interest rate is 6.99% you cannot just add 6.99% each month to the principal. Instead, your monthly interest will be a fraction (one-twelfth), of the total amount you pay over the year (6.99%). In this example, it is 0.5825%.
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Lenders may also charge fees for loans. Tayne says that lenders often charge an origination fee. This is a one-time administrative cost charged when the loan is accepted and received.
Tayne says that origination fees can range from 1% up to 8% of the loan balance. Instead of being added to the loan balance, the origination fee will be deducted from your amount.
Tayne explains that if you borrow $5,000 and your origination fees are 5%, you will only get $4,750 when the lender releases the funds. You’ll still have to pay interest on the $5,000 amount.
How to pay off loans faster
Paying your loan down sooner is one way to lower the cost of your loan. You can lower your overall cost by making extra payments towards the principal and you can pay the loan off before its original term ends.
Before you sign for a loan, make sure you read the fine print. Prepayment penalties can be charged by some lenders if you pay off your loan early. Look for lenders that don’t charge prepayment penalties when searching. You don’t want extra fees if you can get out of debt quicker.
Tayne and Lattman recommend these tips to help you get rid of your debt quicker:
- Don’t borrow more than you actually need
- Reduce discretionary spending, and use the savings to reduce debt
- Refinance at a shorter term with a lower interest rate
- Find ways to increase your income, and use the extra money for debt reduction
- Windfalls can be used to make a lump sum payment towards your principal
- When deciding whether a personal loan is right to you, consider more than the APR and the impact on your finances.
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Lattman states that in addition to the APR, it is important to consider your monthly payment amount as well as your repayment term to see how they fit within your budget. Can you budget for $250 per month for three years?” You might want to reconsider.