by Natalia Jones

Created on: March 20, 2009

Many equate the cost of borrowing money simply to the interest rate. While this may be true to some extent, the total cost of borrowing includes much more that the rate quoted by your banker.

There are several facets that make up the total direct financial cost. These include interest rates, points, penalties and required balances. While most people are familiar with the term interest rate, the others mentioned may be quite unfamiliar. We will define each in turn.

The Interest Rate

This is the percentage that the bank charges for loaning you the principal. The rate may be fixed (one steady rate) or floating (you can negotiate a maximum interest rate cap or a maximum rate).

Points or Fees

These are charged by the lender for servicing the loan (simply writing up loan documents, running credit checks and agreeing to lend you the money at all).

Penalties

There may be fees charged for prepayments. This comes about because in the event that you make a pre-payment towards your principal the lender does not get the amount of interest that it expected to get and so they charge a fee to deter this.

Required balances

This occurs when the lender demands that the borrower places a certain amount of cash in an account held with them (usually a low interest bearing account) as a condition of the loan. This in effect increases the real rate of interest and lowers the principal lent which makes the loan more profitable.

Another cost that should be considered is the opportunity cost of putting your purchase on hold and accumulating the savings to buy it cash instead. By choosing this option, you forego the interest expense along with all the other fees associated with the loan. However, you may evaluate the situation, and decide that the instant gratification coupled with the advantage of having the use of your intended purchase immediately are worth the price of the interest and other charges. Of course, with some types of purchases, such as a home or maybe education, this will not apply.

Before you accept the pen from your lender and sign your name on the dotted line, be sure you understand the terms listed. Knowing the full cost of your loan is not only necessary for you to assess if you are making the best decision, it can also motivate you to pay it off faster, or in the case of pre-payment penalties, avoid unwanted surprises down the road.

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