Become a better investor

Lesson in Course: Investing basics (advanced, 5min )

I'm taking out a loan but how can I tell if the terms are right for me?

It is always a good idea to shop around before making any major purchases. The same is true for when we are planning on borrowing.

Let’s say we are looking to pay for college. There are a lot of banks and other lending institutions out there that might offer us different loan terms; how do we compare and decide which one is right for us?

One way of comparing different loans is based on the total interest paid over the life of the loan; however, this is dependent on the terms of the loan.

While it might be obvious that higher interest rates result in paying more interest over the life of the loan, remember that interest rates are reflective of risk. The creditworthiness of the borrower is known as the default risk.

Borrowers that are deemed less likely to repay the debt will need to pay more interest to convince lenders to risk their money.

The maturity of the loan also carries a level of risk. Loans that take longer to pay back are inherently riskier and therefore will typically have higher interest rates.

The more time until maturity means that there is greater uncertainty about what will happen between now and then. The potential for both positive and negative outcomes is higher.

Even though the total amount of interest is greater, the loan with a longer maturity will have a lower payment each period given the loans have the same principal.

We can see this in action by looking at the amortization tables of two loans. An amortization table simply shows a schedule of each payment and how the balances change. It also shows how much of each payment goes toward paying the interest and principal of the loan.

The principal of both loans is $80,000 and will be paid back monthly; however, Loan 1 will have a 4.5% APR for 10 years and Loan 2 will have an 8% APR for 15 years. Loan 2 has a higher interest rate and longer maturity than Loan 1 so we can expect to see Loan 2 have more interest and a potentially lower monthly payment.

Here, we can see that this loan has lower monthly payments ($764.52). On the other hand, the total interest paid is significantly higher than Loan 1.

Ideally, you want to lower interest as much as possible as a borrower but think about what your cash flow needs are. There is a balancing act between making the payments large enough to reduce the total interest paid but still having enough cash flow to make those payments comfortably. Keep in mind that you’ll have to be able to make the payments through the good times and the bad.