Often the costs of loans can be enough to put us off getting them. There is a financial cost to many of the things that we do though and therefore we will usually accept that we will have to pay to borrow. However, the costs of loans vary a lot and people do worry about taking on a loan that is more costly. It is worth understanding about costs of loans though and how the costing works. This should allow you to better understand the differences between costs of loans and it will also help you to calculate the costs so you can make the right decision when choosing a loan.
What determines the cost of a loan?
The cost of a loan will be set by the lender and it can be easy to think that they higher cost loans are all about the lender making more profit. In some cases this could be true but there are different reasons for setting costs at the levels they are.
- Admin charges – there will always be an administration charge for setting up a loan. It needs a person to check the applicant’s details and put all of the processes in place such as setting up direct debits and checking ID so that the loan can go ahead. This is something which every lender will need to do and some will charge a separate administration fee but others will incorporate it into their interest rate. If you have a mortgage, for example, the administration fee can be spread over decades so it is very small but if you have a payday loan, lasting a few weeks that charge has to be repaid in one go. It can therefore seem more expensive when it could actually be cheaper.
- Borrowing charges – the lender will have to pay to borrow the money that they then lend to you. Conventionally banks use money that people have saved to pay out, so they need enough to pay interest on those savings, but they tend to also borrow from elsewhere and they need to cover the cost of that borrowing.
- Staff costs – all lenders need staff to do all sorts of jobs including customer service which need to be paid. If you want to be able to have your questions answered by someone or have your loan account opened quickly then there needs to be lots of staff available to do this for you.
- Risk costs – a lender takes a risk when they are lending money as some of the people, they lend to may never repay their loans. They have to make sure that they do not go bankrupt as a result of this and therefore charge a bit extra so that they have money to cover this risk.
These are just some of the costs of being a lender but it can help to see where your money goes and why loans can be expensive.
How to calculate the cost of a loan
It is really important to make sure that you know exactly what the loan that you are taking out will cost you. It can be easy to make assumptions about which types of loans will be most costly, but unless you actually work it out you will not know. Looking at the interest rates can make you think that a mortgage will be the cheapest loan and an unauthorised overdraft the dearest but if you look in monetary terms rather than interest percentage you will get a completely different perception.
For example, lets assume you are paying £100 a month in interest on your mortgage and you have that mortgage for 20 years, that adds up to £24,000 in interest alone. Most people pay more interest than that and for longer as well, so they pay a lot of money for that loan. However, there are many advantages in owning a home so they would argue it was good value for money. Compare that to a credit card where you might be paying £30 in interest a month then the cost of that will be less, especially if you pay it back more quickly. However, you need to decide whether you think that the loan is giving you good value for money.
It is also important to make sure that you include all costs of the loan. Just looking at interest rates will not be enough as it may not include other charges which are added on as well. The AER percentage will give you the equivalent interest rate including any additional fees, but if you do not have that figure then get in touch with the lender. They should be able to let you know how much the loan will cost and that will allow you to be able to compare the costs of different types of loans.
How much are payday loans?
For a payday loan you should be able to ask the lender what the cost will be but there is often a calculator on the website so that you can work it out for yourself. You will often just be able to put in the amount that you wish to borrow and how long for and it will let you know how much you will need to repay in full. You will then just need to take away the amount that you borrowed from this figure and that will tell you how much it costs. You will be able to do this with different payday loans and that will enable you to compare them on cost.
It is worth noting though that the costs could go up. This should not happen due to interest rate changes or the lenders policy changes but if you do not repay the loan when necessary. Like all loans, there will be fees to pay if you do not repay the loan on time and this will make the loan more expensive. These fees vary between lenders and so if you think that there is a chance that you will not repay on time, then take a look at these charges as well so that you have an idea of how much extra you may have to pay and how the amounts vary between lenders.