Do You Know How Much You’re Really Borrowing?
Borrowing money is never an ideal solution to cashflow problems. But in today’s world, many of us have no choice. Whether we take out loans, have credit card debt, or get payday loans, money borrowing is a way of life in many households. Before borrowing money, however, it’s essential that you understand exactly how much you’re borrowing. And things might not be as simple as you think.
Borrowing Isn’t Simple
If you borrow £20 from you friend, you pay him back £20 the next time you see him. Easy. But borrowing from a company (a bank, credit card company, or loan provider) isn’t as simple as that. Obviously, these companies need to make money, so you’re going to end up paying back more than you borrow.
You probably know about interest, and can make a fair guess that if you borrow £1000 from your credit card company you’re going to be paying back more than £1000. But how much you pay back isn’t just a question of interest. There are actually five different things that affect your payback amount.
What Affects How Much You Pay Back
Let’s say you need a loan of £2000 to pay for a big family holiday. You’ll probably fund this by paying for your vacation on your credit card. Or maybe you need to do some work on your house, so you borrow £5000 from you bank. Either way, you’re going to be paying back more than you borrowed. How much you pay back is determined by five things:
- The loan amount: e. the total amount that you borrowed
- The fees: these are extra charges that the company adds to the cost of your loan to cover things like administrative expenses
- The repayment schedule: whether repayments are monthly or if there are lump sum payments
- The loan length: how long you need the money for and when you can pay back the amount by
- The interest rate: the percentage of the loan that the company adds to the total fees as a fee for borrowing the money
How does each of these things influence your borrowing? Let’s look at each of them in more detail.
The Loan Amount
This one is simple, if you borrow £500 then you’ll pay back at least £500. If you borrow £5000 then you’ll pay back at least £5000. However, there’s an added point here in that many companies charge different interest rates depending on how big the sum is that you want to borrow. It may end up costing you a lot more to borrow £501 than it does to borrow £499 simply because the institution you’re borrowing from charges a certain interest rate for loans up to £500 and a larger interest rate for loans above that amount.
Another simple one. Most institutions charge fixed fees for processing loans and administrative costs. When borrowing you should always ask about fees and check the small print of any contracts as well. These fees are unavoidable, unfortunately.
The Repayment Schedule
Whilst many institutions require monthly payments, not all do. And even if you do have monthly payments, some lenders also accept “lump sum” payments where you can pay off a big chunk of your debt at one time. In most cases (and counter-intuitively) you’ll usually end up paying MORE in interest if you pay lump sums than if you pay regular monthly payments. A regular monthly repayment schedule tends to be the cheapest way to borrow money. A big lump sum payment can mean much higher interest rates.
A Note on Minimum Payments
Whilst we’re talking about payment schedules, it’s important to mention minimum payments. Some companies, particularly credit card companies, have something called a minimum payment. This means that there’s a minimum you can pay each month without getting a penalty, but you can also pay more if you like. Paying only the minimum payment on a loan is NOT a good idea, you should always pay more if you can.
A minimum payment is usually a percentage of how much you’ve borrowed, which means it gets lower over time as you pay off your loan. Paying only the minimum payment means it will take you MUCH longer to pay off your loan, which in turn means you’ll be paying interest for longer, and that means that the total amount you end up paying back is more.
Even adding an extra £10 to the minimum monthly payment will help save you money in the long run!
The Loan Length
The shorter the length of your loan, the less money you’ll pay in interest over the course of the loan, which means you’ll pay less to borrow money overall. It might be tempting to go for a longer loan term since monthly payments will be lower, but in truth, that shorter loan is a better plan.
Don’t believe it? Hypothetically, let’s say you borrow £5000 at an APR (we’ll get to explaining APR in a moment!) of 11.72%, which is pretty standard. Over the course of a three-year loan, your monthly payments will be £165.40, which comes to a total of £6631 over three years. On a five year loan, on the other hand, your monthly payments might be only £110.52, but that comes to a total of £7298 by the end of the loan period!
The Interest Rate
If you borrow money you’ll be charged interest on that sum until you’ve finished repayments. This adds a lot to the cost of borrowing. Interest rates on loans are given in a percentage with the abbreviation APR (which stands for “annual percentage rate of charge”). As you can probably guess, the lower that percentage, the better since you’ll end up paying back less money over the course of your loan.
A Note on APR Rates
Many loan companies, credit card companies, and banks advertise quite heavily, and most will include an APR in their advertisements. Be aware that UK law only requires companies to give 51% of their customers their advertised APR. Just because a company advertises a great APR does NOT mean that you will receive it! Always check your APR before signing for a loan.
So How Do I Know How Much I’m REALLY Borrowing?
Borrowing £5000 isn’t just a question of paying back £5000. You’ll need to take into account all five of the above factors to figure out the overall cost of borrowing the amount that you need. This can involve some complicated maths, but there are loan calculators available online to help you out. You can find a couple of examples here and here, though most banks and credit card companies also have loan calculators on their websites.
Be aware that these loan calculators are only a guide and may not give you the exact amount you’ll end up paying back (many of them don’t include fees from the company that you’re borrowing from, for example). They’ll give you a good idea of what you’re getting into, but it’s up to you to check all the possibilities before signing for that loan or spending on your credit card.
Before You Borrow
Borrowing money can be an expensive business, and it’s very easy to get into debt if you don’t realise the true cost of borrowing. It’s important that before you borrow (or run up your credit card) that you consider a few things.
The first of these considerations is whether or not you really need to borrow money at all. Is what you’re planning on buying essential? A family holiday might sound nice, but is it really worth getting into debt for? Especially when that holiday is going to end up costing you way more than the ticket price. Also consider whether you can better pay for what you need through savings or even a personal loan from a family member, rather than needing to pay fees and interest to a lending institution.
And obviously, you’ll need to take a look at how much your repayments are going to be using all the above factors before committing to borrowing!
How Much Can You Repay?
The key important factor when borrowing money isn’t how much you can borrow, or how much you can afford to pay each month, or which bank you use, or anything else. There is one over-riding question that you have to ask yourself before borrowing:
How Much Can I Afford to Repay?
You’ll need to work out the total cost of borrowing a sum taking into account APR, loan length, and everything else before deciding that you want to sign on the dotted line!