Financial Education
Borrowing on your terms
A fact of life is that we all need to borrow money from time to time. But before you're caught in a financial crisis, it's worthwhile for you to learn how to accurately evaluate various lending options. Why? Because all loan options are not the same. In the haste of the moment, when you're desperate for cash, you may not be paying enough attention to what a loan is really costing you.
Let's look at an example. Say you need $300 right away, and there are no friends or family members available to lend you the money. Instead, you need to consider other short-term loan options such as a credit card cash advance, a signature loan from a bank or credit union, or a cash loan from an instant check-cashing store or payday loan operation. How do you know which option is best? The answer is not so simple, because there are lots of factors that play a part in the decision: availability and likelihood of approval, convenience, disclosure, confidentiality, and of course, whether the loan is fairly priced.
Assuming that all sources can and will lend you the money; are convenient to you; provide complete lending information; and agree to keep your transaction confidential, that leaves the critical criterion of price. Price in this case refers to the cost of financing.
One common evaluation method of cost comparison is Annual Percentage Rate (APR), so that's what we'll use in this example.
The ABCs of APR
APR is a standardized formula for determining loan costs, introduced for the protection of borrowers by the Consumer Credit Act of 1974. Today, APR disclosures must comply with the Truth in Lending Act and Regulation Z, which means the total cost of a loan must include interest charges, loan fees, and points (one point is equal to 1% of the principal loan amount).
Going back to our example of borrowing $300, let's say that you've met with a lender who will loan you the money for a $20 origination fee and no interest. Is this a good deal? Well, if you had written a bad check instead, the bank could have charged you $30 or more for insufficient funds. Seems pretty good by comparison. A credit card cash advance would have cost you a $5 fee plus monthly compounded interest. Still pretty good. Even an ATM withdrawal of your own money (if available) often has fees of $2 to $10. Based on these factors alone, the cost seems fair. Now let's evaluate based on APR by looking at the table below:
The first thing you notice is that the longer the period of time you're given to repay the loan, the more economical the rate becomes. If the lender's terms are that you pay back the loan in one week, then the effective cost to you is 346.7%. On the other hand, if you are given a full year to repay the loan, the cost is only 12.1%. Quite a difference. This example clearly demonstrates the effect that the term of the loan has on APR. The fee of $20 never changed, but the APR changed drastically.
Although evaluating short-term borrowing costs using APR can be misleading, using APR to evaluate long-term loans is very effective.
If you were to compare a home loan from different lenders with two different rates and origination costs, you would discover something very interesting. Referring to the table above, if you only planned on being in the home for three years, the higher interest loan (8.5%) plus points is actually "cheaper" at 9.53% than the lower interest loan (8%) plus points, which is 10.44% at three years. (Note: Found mainly in mortgage, a point -- which equals one percent of the total loan amount -- is an up-front fee that lowers your monthly interest rate and total interest due over the life of the loan.)
The bottom-line message? You can't just focus on rates and fees alone in determining the real cost to you, especially borrowing over a shorter period. The term of the loan must also be considered. You would discover that the $300 loan for two weeks at a cost of $20 may be a good deal if done once and why that same loan renewed biweekly for 12 months is not such a good deal.
Therefore, when faced with having to borrow money, be sure to ask the right questions, insist on full disclosure, and weigh both APR and effective terms to properly compare loan benefits and prices.
RSS Feed