Most people will probably borrow money at some point in their lives. Maybe it’s to buy a car, pay for college, or eventually purchase a house. But even though loans are such a normal part of life, I don’t think most people really understand what they’re paying for when they borrow money.
When you take out a loan, a lender gives you money upfront and you agree to pay it back over time. The amount you originally borrow is called the principal. But you usually don’t just pay back the exact amount you borrowed. The lender also charges interest, which is essentially the cost of borrowing that money.
That made me wonder, why should borrowing money cost anything?
The answer is that lenders are taking a risk by giving you money today and waiting to be paid back later. Interest compensates them for providing the money and taking on that risk.
You might also hear two terms when looking at loans: interest rate and APR. The interest rate tells you the rate charged for borrowing the money. APR, or annual percentage rate, is broader because it can also include certain fees, giving you a better idea of what a loan actually costs.
Another important factor is the loan term, or how long you have to pay the money back.
The Consumer Financial Protection Bureau gives an example of a $20,000 car loan at 4.75%. With a three-year loan, the monthly payment is about $597 and the borrower pays $1,498 in total interest. With a six-year loan, the payment drops to about $320, but total interest rises to $3,024.
That’s more than twice as much interest simply because the loan lasts longer.
This is why looking only at the monthly payment can be misleading.
Imagine one dealership offers you a payment of $400 a month and another offers $300. The $300 payment sounds better. But if the first loan lasts four years and the second lasts seven, you could end up paying much more overall with the lower payment.
Interest rates can make the difference even bigger. Imagine borrowing $30,000 for a car over five years. At 4%, you’d pay roughly $3,100 in interest. At 9%, you’d pay more than $7,000.
A difference of only a few percentage points can mean thousands of dollars.
This is one reason your credit score becomes so important.
As I talked about in my last post, your credit score helps lenders estimate how risky it might be to lend you money. A stronger credit history can help you qualify for better rates, while a weaker one may lead to higher rates or fewer options. That means your credit score can directly affect how expensive borrowing becomes.
And this doesn’t only apply to cars.
Student loans can take years to repay, while mortgages can last for decades. When you’re borrowing large amounts of money for long periods of time, even a small difference in the interest rate can add up significantly.
This is why understanding loans matters even if you aren’t borrowing money right now.
When you’re younger, a loan can seem simple: borrow money, make a monthly payment, and eventually you’re done. But there is much more happening underneath that payment.
You’re paying back the principal, paying interest for the ability to borrow the money, and potentially paying additional fees. Your interest rate, APR, loan term, and credit history all affect how expensive that borrowing becomes.
The biggest thing I took away from learning about loans is that the number you should care about isn’t always the monthly payment.
Before taking out a loan, you should ask how much you’re borrowing, what interest rate you’re getting, what the APR is, how long you’ll be paying it back, and most importantly, how much you’ll pay in total.
A loan can help you buy something you couldn’t afford upfront, but that doesn’t mean the money is free.
You’re paying for the ability to use someone else’s money today.
And understanding exactly what that costs is one of the most important parts of becoming financially responsible.
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