When shopping for loans, it is easy to get overwhelmed by choice. As you start to look closer at lenders’ it can seem that things only get more complicated, with an APR which is different from the interest rate advertised, extra fees and need to decide how and when you want to pay your loan back.
However, a little understanding of how loan payments are calculated could help you ask the right question and make it easier to spot a good deal from the beginning.
Loan Borrowing Costs
Whether you’re borrowing with a mortgage, personal loan or using your credit card, there are three main elements which come into play when working out repayments.
The total cost of a loan beyond the capital you borrow is affected primarily by fees, interest and the length of the loan; once you know these, it is possible to work out how much you’ll make in repayments.
The fees of a loan are fixed sums of money that the lender charges for providing a service or for violating the terms of the contract.
They could be one-off, recurring, or triggered by the borrower’s behaviour. An example of a one-time fee is the arrangement fee for a mortgage, which the lender charges to open an account. A recurring fee could be the amount a lender charges each month for you to have access to your credit card.
Late payment penalties or early repayment charges are fees which the lender charges in response to certain actions taken by the borrower.
When you borrow money, you will almost always have to pay interest; this is how lenders make a profit. The interest rate on a loan is a percentage of the loan balance, which the lender charges as a service fee.
For example, on a loan of £100 with an interest rate of 3%, a borrower would pay £3 in interest and £103 in total. When you make a standard loan repayment, part goes towards paying off the money you borrowed, and part goes towards the lender’s interest.
Credit Rating & Interest
Your credit rating is your financial footprint. It tells lenders about your past financial behaviour, how much money you owe, and whether you’re a reliable debtor. Lenders use credit ratings to try and predict the risk of lending to individual borrowers.
If you have a good credit score, it tells lenders that you have been consistent repaying your debts in the past and have a healthy financial profile. Lenders can be fairly sure that you will pay back your loan in full and on time, so you’re likely to be charged fairly low-interest rates.
However, if you have a bad credit rating, it points to potential financial problems. You may not have paid back loans on time in the past or could already have excessive amounts of debt eating into your budget.
Lenders tend to charge higher interest rates to people with poor credit ratings, to offset the risk that the borrower might not be able to pay them back.
In rare circumstances, you might come across an interest-only loan. Unlike with standard repayment loans, your payments only go towards paying off the interest on the capital you borrowed.
This means that your loan repayments will be lower than if you were paying off the interest and capital together, but you will still owe all the capital at the end of the loan and need to find another way to pay it off as a lump sum.
How Long You Want to Borrow For
The length of your loan has an effect on the size of your monthly repayments as well as the overall cost. If you spread your repayments over a more extended period, your repayments will be smaller.
For example, it costs £10 per month to repay £100 over ten months, but just £5 per month to repay it over 20 months.
However, the longer you stay in debt, the longer you’ll be charged interest. For example, you would pay £9.74 in interest over 12 months if you borrowed £100 at 19% APR, but if you spread your repayments over two years, you would pay a total of £19.26 interest.
The amount of interest you owe is calculated on your outstanding balance at regular intervals over the course of the loan, meaning you end up paying more of it the longer you take to clear your debt.
Percentage of Household Income Spent on Monthly Mortgage Repayments
|Yorkshire and the Humber||23|
Working Out Repayments
To accurately work out the repayments on your loan, you should know the interest rate, how long you want to borrow for, and any fees you’re expecting to be charged. You can then use a loan calculator to work out how much it would cost you to repay your loan.
Alternatively, you could ask your lender for the APR on the loan. The APR includes the cost of interest and fees together, so you only need to think about how long you want to borrow for when working out repayments.
How Much Can You Afford to Pay?
It would help if you thought about how much you can afford to pay each month before applying.
As a rule of thumb, it is best to try and keep your total debt repayments below 35% of your monthly income.
If you spend more on debt than this each month, you could find yourself struggling to meet other essential expenses and lenders could refuse to loan money to you if you need a top-up.
Borrowing more than you can afford to repay also risks landing you in financial difficulty.
If You Are Shopping for a Mortgage
If you are shopping for a mortgage, you can use the 28/36 rule to work out how much you can afford to pay each month. According to the rule, you should aim to not pay more than 28% of your monthly income on mortgage repayments and associated costs.
When you add your mortgage repayments to all your other debts and loan repayments, these shouldn’t come to more than 36% of your monthly income.
For example, if you earn £1600 per month before tax, you should not pay more than £448 per month in mortgage repayments. In total, the amount you spend on loan repayments each month should not be more than £576.
This is not a hard and fast rule but can be helpful in working out how much you can afford to pay on your loan.
If taking out a loan would push your repayments well over these limits, you might need to think about whether you can really afford it.
When comparing options, you should look at several factors, not just the monthly repayment. Although it may be tempting to opt for the lowest repayment figure, doing so could lead you to spending thousands more in the long run on interest.
The table below shows how you might compare interest rates and repayments on three different borrowing options:
|Loan (£5,000)||Interest Rate (% APR)||Length (Months)||Monthly Repayment||Total Repayable||Total Interest Paid|
|Personal Loan A||11||18||£301.40||£5425.11||£425.11|
|Personal Loan B||18||9||£594.84||£5353.59||£353.59|
How Can Flexy Loans Help?
Here at Flexy Loans, we have partnered with some of the UK’s leading Lenders.
They have already helped thousands of people get loans already, and they can do the same for you.
Choosing a loan broker like us (we don’t charge any fees) means our application process matches you with the best loan available to you. All lenders we recommend are regulated by the FCA, which gives you an additional layer of protection.
To apply and see what loan is available to you, click on the below and answer the questions