How do Loan Repayments Work?

Before you borrow money, it is in your best interest to learn exactly how loan repayments work. Most people know if you borrow money, you have to eventually pay it back. But most of the time, there’s a little more to it than that. The more you know, the more capable you will be of making the wisest decisions with your money. Here’s what you need to know.

Getting the loan

The first step in the loan process is applying. Your credit score is one of the biggest factors used in determining whether or not you get the loan and how high your interest rate will be. The better your credit, the better your interest rate will typically be. Most lenders use a FICO score to determine this, which you can see for yourself on major credit bureaus’ websites. The scores range 350-850, with anything above 700 considered “good.” You also need to be aware that whenever a lender checks your credit, it can slightly affect your score. Applying for one loan every six months probably won’t affect it much, but if you apply for several at a time, your score could take a hit. Do a little research ahead of time to find the best lender so that you don’t have to apply several times to find the best deal. Institutions like a credit union in New Orleans, LA often offer the most reasonable terms.

Understand your interest rates

Unless you’re borrowing from your parents or a generous uncle, your lender will be adding interest to the principal amount of your loan. And every type of loan calculates interest rates a little differently. Some lenders use simple interest and some use compound interest. Simple interest is a basic formula:Interest = Principal x Rate x Time

So, if you borrow $100 at a 10 percent interest rate, the entire amount you would pay back in a year would be $110. But even if you pay back the loan early, unless there is a special clause in your contract, you will still owe some interest. It would just be figured on one half (.5) years instead of one.

Some lenders, on the other hand, use compound interest. So, not only does the interest accrue based on the original amount of the loan, but you also get charged interest on the interest and fees that have accumulated. This type of interest is actually more commonly used than simple interest. Compound interest is a little more complicated to calculate, but there are calculators available online to help you determine exact amounts. Or you can use the basic formula to calculate it by hand.

A = P (1 + r/n) (nt)

Know your payment options

Because most loans are calculated with compound interest, you are not simply paying down your loan amount every time you make a payment. In fact, many large loans, such as mortgages can consist of payments that are all or mostly interest in the beginning. But most lenders split the loans into two parts. One part goes toward interest and the other toward the principle. This is called amortization. This is calculated based on a set payment amount that will be paid over an agreed-upon period of time.

In order to pay off an amortized loan early, you will need to add a little extra to each payment you make or call your lender for a payoff quote to pay one lump sum. Paying your loan off early can save you thousands of dollars in interest, but there is a catch. Some lenders actually have stiff early payoff penalties to keep their borrowers from saving all that money. This is because they have calculated that interest into future revenue projections and want to protect themselves from unexpected changes to that revenue. This is something you need to cover before you agree to any loan. Make sure you know their loan terms in case there’s a chance you’d like to pay it off early. Many people find that they are thoroughly interested in the topic of lending and interest. If this is you, you may enjoy attending one of the accredited liberal arts degree programs where you can continue your studies and enhance your learning.