Credit is everywhere! From auto loans to mortgages to credit cards, there’s a whole lot of credit everywhere. The older you get, the more people will try to sell it to you. The bottom line is that all that credit costs you money—and some loans will cost a lot more than others. It’s all too easy to get trapped in a very expensive loan.
Once you understand how loans work, you’ll be armed with the knowledge to decide the best type of credit for any situation.
What is credit exactly?
Credit is borrowing money under contract. A lender gives you money to buy something now and you sign a contract agreeing to pay it back by making payments over time.
Credit is not free. You pay for credit in interest and sometimes in fees.
How much you pay depends on 5 important facts.
1. The higher the rate of interest, the more you pay.
Interest greatly affects the cost of your loan, so let’s explore it a little bit more…
Interest is the amount you pay to use someone else’s money. Lenders quote this rate to you as an Annual Percentage Rate, or APR.
Let’s say you borrow $1000 at 10% APR. Well, 10% of $1000 is $100. Does that mean you will pay $100 in interest? No way! That would be too simple!
2. Interest is added to your loan balance every single day.
- Interest knows no holidays or weekends. The more days you have your loan, the more interest you will pay overall.
- For most loans, you can pay extra anytime you want (but never less!).
- Paying more than the amount due will reduce the total cost and total time it takes to pay back your loan.
3. The longer your loan term the more you will pay.
- Term is the amount of time you take to pay back your loan. Because interest is added to your loan every day, the more days you have your loan, the more you will pay overall.
Important Tip! The longer your loan term, the lower your payment. Many people make the mistake of only thinking about a low payment when borrowing money. The loan with the lowest payment isn’t always the best choice. Always read your contract carefully to determine the true total cost of the loan.
4. The higher the risk to the lender, the higher the rate will be.
(Remember, a higher interest rate means a higher cost to you!)
In general, loans with a higher risk to the lender will cost more (have a higher interest rate) than loans with a lower risk. Risk is how much money the lender will lose if a borrower doesn’t pay back his or her loan.
Lower Lender Risk: Secured Loans
- A “Secured Loan” is a loan secured by something of value (collateral)—like a car or a house. If the borrower doesn’t pay the loan as agreed, the lender can sell the item to get as much money back as possible. This is called a repossession or “repo.”
- Lenders charge less interest for secured loans than unsecured loans.
Higher Lender Risk: Unsecured Loans
- An “Unsecured Loan” is not secured by any property—only your promise to pay back the money you borrowed.
- Most credit cards are unsecured loans.
- Lenders charge more interest for unsecured loans than secured loans.
Lender Risk: Your Credit History
- If you have a good credit history, you’ve shown that you have responsibly paid back other loans and are therefore more likely to pay back another loan.
- The better your credit history, the better your rate.
- Learn how you can get and maintain the best credit history here.
5. The more you borrow, the more you pay.
- Mortgage loans are typically paid over 30 years—that’s 360 payments!
- If you borrowed $200,000 at 6.00% APR, you would pay $231,676 in total interest over 30 years (that’s in addition to the amount you borrowed). Yes, that is more than you borrowed in the first place!
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