People usually look at monthly payments when they’re thinking about taking out a loan. And while payments are important, they don’t give you a complete picture of what a loan really costs. To figure out if a loan is affordable, you must consider interest rates.
Interest and Payments
The monthly payment on a loan includes the principal, which is the amount you borrow. If you take out a loan for $2,000, that $2,000 is your principal, and you pay part of it back every month. Your monthly payment, however, also includes interest, and how much interest you pay depends on the interest rate. Interest rates can apply to different periods of time, but every lender should tell you the interest rate for a year, which is called the annual percentage rate or APR. If your $2,000 loan has an APR of 12 percent, you’ll pay $240 in interest on that amount over a year because $2,000 times 0.12 is $240. If the loan has an APR of 20 percent, you’ll owe $400 in interest over a year. A loan with an APR of 20 percent is a lot more expensive than a loan with an APR of 12 percent, even though you borrow the same amount of money in both cases.
How Interest Rates Affect Your Payments
Interest rates can affect your payments in two ways. First, a loan with a higher rate may have higher monthly payments than a loan with a lower rate while taking the same amount of time to pay off. Second, a loan with a higher rate may have similar monthly payments to a cheaper loan, but it could take longer to pay off. In the second case, you’re paying less of the principal each month, so a larger portion of each payment goes to interest. Since a cheaper loan and an expensive loan may have the same monthly payment amount, the monthly payment by itself is not a good indicator of how much a loan costs.
To compare two loans, look at their APRs. You generally want to choose the loan with the lower APR. However, some lenders charge fees that are not included in the APR, so you should also learn about any extra charges that relate to the loan. Choose the loan that is cheaper when you consider both the interest rate and fees.
The amount of your monthly payment matters because you must make sure there is room in your budget to pay it each month. But by itself, the payment amount doesn’t tell you how much a loan costs. Interest rates are what matter when you shop for a loan.