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Meet Lucy. Lucy has been working at Corporate Co. for the past three years. Since her very first day on the job, Lucy has seen her colleagues refinance students loans (Zoe), purchase cars (Joan), and evenbuy houses (Emily).
Lucy wants to be like them, there’s justone problem: all these activities require loans, and Lucy just doesn’t feel confidenthandling them. What should she to do? Well, her first step is simple: understandhow loans work.
On their most basic level, loans are simply borrowed money. Lenders, such as banks, can give borrowers, such as Lucy, a fixed amountof money called principal, like $10,000 to buy a car. However, the bank isn’t giving Lucy this money for free.
In addition to paying back her principal, they’ll require Lucyto pay a certain amount of money each month, called interest, just for using their money.In addition, if her loan is secured, as many are due to their more attractive interestand approval rates, the bank can seize actually the asset, in this case her car, if she failsto repay.
So how is this interest calculated exactly? Let’s explain through an example. Let’s say Lucy’s $10,000 car loan comeswith a 5% annual interest rate. Divide that 5% by 12 months, and you get roughly 0.4%,the monthly interest rate. That’s means Lucy owes the bank 0.4% of her outstandingprincipal each month in interest.
While this seems reasonable enough, interestrates come with three more complications: One: Not all interest rates are fixed. Some,called variable interest rates, can change over time, often quite dramatically. Becauseof this, they can be quite risky, especially on long-term loans.Two: the interest rate of a loan is not the same thing as its APR. APR includes both theinterest rate, either fixed or variable, and the fees. Thus, when comparing loans to seewhich is cheaper,
Lucy should always use APR, not the interest rate.Three: APRs are also highly dependent on your credit score, as the lower your score, thehigher your APR. For more details on this, be sure check out our next video “CreditScores and Reports 101”. So that’s interest rates. But unfortunately,they aren't Lucy’s only concern. She also must pay back a certain amount of her principaleach month. This payment, combined with interest, makes up Lucy’s total loan payment, whichis the money you pay the bank each month. Should Lucy want to calculate this numberherself, all she’ll need is an online calculator, like ours, and three numbers: the amount ofmoney borrowed, the interest rate, and the length of the loan, also known as its term.
This term is a critical number, especially when choosing a loan. That’s because, in general, the shorterthe term of the loan, the greater your monthly loan payment. This should make sense. Afterall, the less time you give yourself to repay the loan, the more you'll have to pay each month to compensate. And while this may seem bad, shorter termloans can actually be great, for two reasons. One: They come with in herently lower interest rates.
And two: Because their monthly payments aremuch larger, the borrower is forced to pay down the principal much faster, which ultimatelymeans less interest charged over the life of the loan. This fact is so important that we’ll repeat it.
The shorter you can make your loan, either through extra-debt repayments or a shorterterm, the less interest you’ll pay in the long-run.
