The True Cost of a Loan: All Elements Explained

If you apply for a loan, you will receive an offer to review. That offer will lay out the terms of the loan and the cost. Still, many borrowers miss the fine print when they accept a loan. Even though they have looked over the paperwork, they may still not understand the full cost. Letâ€™s take a look at all of the costs which factor into a loan. That way you will know how to calculate exactly what you will owe with no surprises.

The Main Elements of the Cost of a Loan

The amount you are borrowing

This is the amount of money that the lenders will give you. It is straightforward, but it still deserves due consideration, as you will owe back the entire amount that you borrow. So make sure that you can afford to pay it back within the loan term.

The interest on that amount

Interest is the leading price you pay for borrowing money. It basically calculated as a given rate applied to the loan amount over a one-year period, multiplied by the number of months you borrowed the money for. There are two main types of interest rates:

Fixed interest rate – stays the same for the entire duration of the loan term
Adjustable interest rate – changes. You can typically expect it to rise higher and higher

Fees

Fees are a fixed amount of money related to certain specific elements of the loan process, that are applied not directly to the principal, but rather to the “lending process”.

Calculating Interest on a Loan

The most complicated part of figuring out the cost of a loan is calculating the interest. Interest is the leading price you pay for borrowing money. Imagine the lender had the money sitting in a bank account somewhere. It would accrue interest since the bank is effectively borrowing it. Since you have the money, that does not happen. But the lender still wants the money to earn interest, so you get charged interest instead. The only motive any business has to lend you money is to make a profit off of it. That is what interest is for.

Fixed Interest-Rate Calculation

Here is a calculation to help you figure out the monthly interest on a fixed rate loan:

(Fixed Rate / 12) x Loan Principal = Monthly Interest

Variable Interest-Rate Formula

Here is the formula to help you determine the monthly interest on a variable rate loan:

(Variable Rate / 12) x Loan Principal = Monthly Interest

Example of Fixed-Rate Monthly Interest Calculation

This is most easily understood with an example. Imagine you are borrowing $1,200 and will make monthly payments:

Number of Payments in a Year = 12.
Loan Principal = $1,200.
Letâ€™s say that the Interest Rate = 10%.

Now, it is essential to understand that interest is always based off of the remaining principal due. Here is how it gets recalculated.

Month 1

(0.10 / 12) x $1,200 = $10

Letâ€™s say you agreed to pay $100 a month on your loan principal. At this stage, you will pay $100 on the principal, plus the $10 in interest we calculated.

Month 2

(0.10 / 12) x $1,100 = $9.16

The new balance was $1,100. Respectively, for month 2 you would pay another $100 on your principal, plus $9.16 in interest. What's the new balance?

Month 3

(0.10 / 12) x $1,000 = $8.34

Right, the balance at the beginning of the month was $1,000, and for that you will need to pay $8.34 in interest.

...And So On

(% / 12) * Balance = Interest

Try it yourself now. Run these calculations over the lifetime of the loan, and you will be able to add up all the interest.

Remember, you subtract all the payments only on the principal, not the interest payment, which does not apply toward the principal. That means that every month, the interest gets recalculated based on the left balance. See table below for a better understanding.

Interest Calculation Table

Month	Interest / Months	Principal Due	Interest for the Month
1	(0.10 / 12)	$1,200	$10
2	(0.10 / 12)	$1,100	$9.17
3	(0.10 / 12)	$1,000	$8.33
4	(0.10 / 12)	$900	$7.50
5	(0.10 / 12)	$800	$6.67
6	(0.10 / 12)	$700	$5.83
7	(0.10 / 12)	$600	$5
8	(0.10 / 12)	$500	$4.17
9	(0.10 / 12)	$400	$3.33
10	(0.10 / 12)	$300	$2.50
11	(0.10 / 12)	$200	$1.67
12	(0.10 / 12)	$100	$0.83

We kept the numbers simple for this example so you could easily follow the math. If you add up all the interest, you get a total of $65. But remember, the reason it comes out lower than you might expect is that of the monthly recalculating. The amount of interest you owe drops each month along with your principal. So over time, you are paying less and less. Now you see why it is more convenient to make advance payments towards the principal? Be careful: the costs of a loan can add up fast! The actual cost of a loan goes far beyond the principal plus the interest. You now have a stronger understanding of how to calculate interest, and you know what other fees to be on the lookout for. Make sure to add up all of these costs when determining whether you can afford a loan.

Common Loan Fees

Now letâ€™s talk about the additional costs you can expect with a loan. Application fee: This is a fee a customer pays to apply for a loan, whether the loan is approved or not. Origination fee: In some cases, this is synonymous with the application fee. In other cases, it is an additional fee paid upon approval. Processing fee: The processing fee covers the background check, credit check, and so on during the processing of the loan application. Closing fee: This is a fee which you can expect to pay with a mortgage and some other types of loans. The buyer and or seller may cover it. Included in the closing fee are a variety of costs for legal services, inspections, and so on. Annual fee: This fee is most common with credit cards and lines of credit. Prepayment fee: This is a fee which a borrower may be charged as a penalty for paying off a loan early. It may apply to any loan. Late fee: If a payment is late, the borrower may be charged a late fee. Not only are late fees lost money, but being charged with one generally means that credit takes a hit as well. Overdraft fee: An overdraft fee may apply if you overdraw a line of credit. Brokerage fee: When applying for a loan through a broker, the broker may sometimes charge a fee to connect a consumer with offers from different lenders. Underwriter fee: This is a fee to pay for the services of the underwriter who assesses your risk for a personal loan. Credit insurance fee: This is an optional monthly fee which provides you with insurance coverage against late payments. Collection agency recovery fee: If a loan gets sent to collections, the cost of the collections service may be forwarded to the borrower. Payment convenience fee: Borrowers who pay through a debit or credit card may sometimes be charged a payment convenience fee. NOTE: This is not an extensive list. There may be other types of loan fees you encounter which are not included here. Not all of these costs apply to every loan either.

References and Sources

1. Understanding the Cost of a Loan. Us.Accion.Org. Available at https://us.accion.org/resource/understanding-cost-loan-0/ 2. Matthew D. Diette (2000). How do Lenders Set Interest Rates on Loans? Available at https://www.minneapolisfed.org/article/2000/how-do-lenders-set-interest-rates-on-loans 3. Understand How Interest is Calculated and What Fees are Associated with Your Federal Student Loan. Available at https://studentaid.gov/understand-aid/types/loans/interest-rates 4. The Truth About Interest Rates for Term Loans. Us.Accion.Org. Available at https://aofund.org/resource/truth-about-interest-rates-term-loans/ 5. Interest Rate Calculator. Calculator.Net. Available at https://www.calculator.net/interest-rate-calculator.html 6. Current and Historic Loan Charges for Ordinary Capital Loans. Isbdocs.Iadb.Org. Available at http://idbdocs.iadb.org/wsdocs/getdocument.aspx?docnum=EZSHARE-1436601171-396 7. Understanding Interest Rates. Edvisors Network, Inc. Available at https://www.edvisors.com/college-loans/terms/understanding-interest-rates/