Hidden Rates & Fees: How Much Are You Really Paying for Your Loan?
The interest paid and total cost of a loan can be two vastly different amounts. This is a difference in interest rate and annual percentage rate (APR). The interest rate represents the cost of borrowing the principal loan amount. The APR is a broader measure of the cost of a loan as it includes the interest rate as well as other costs (e.g. origination and closing fees). Where the interest rate calculates monthly payments, the APR calculates the true total cost of the loan. As a general rule, the APR is greater than or equal to the interest rate of the loan.
Below is a comparison:
Jessie wants a $100,000 loan for a one-year term. Loan A has an interest rate of 16%, while Loan B and C have interest rates of 12%. At face value, Loans B and C appear to be cheaper with the lower interest rate, but let’s take a deeper look at the loan terms.
Loan A has an interest rate of 16% and does not charge an upfront fee, so the interest rate is equal to its APR at 16%. This will be especially beneficial if Jessie decides to prepay as illustrated in Chart 1.
Monthly Payment: $9,073.00
Total Cost: $108,877.03
Loan B has a 12% interest rate and a 4% origination fee. Jessie would prepay the origination fee of $4,000. While the monthly payment is lower than Loan A, the total cost is higher, resulting in a higher APR of 19.83%.
Monthly Payment: $8,884.88
Total Cost: $110,618.55
Some lenders add the origination fee to your principal amount. Instead of paying the fee at the beginning of the loan, it is added to your principal, increasing your monthly payment.
Loan C has a 12% interest rate and a 4% amortized origination fee which is added to the principal amount. Therefore, Jessie would pay 12% interest on $104,000, causing a higher monthly payment and total cost, and an APR of 19.52%.
Monthly Payment: $9,240.27
Total Cost: $110,883.29
By looking beyond the sticker price interest rate to understand the true cost of a loan, Jessie can make a more informed decision about which loan option works best.
How prepayment affects loan cost
We’ve demonstrated that the loans without an origination fee result in a lower cost to the borrower when held to a full term. It is important to highlight that this additional cost is multiplied in cases of prepayment. In fact, the true realized APR can exceed 60% for Loans B and C if they are prepaid after the first month, whereas Loan A stays consistent at a 16% APR even if prepayment occurs.
The importance of shopping around: While sticker price interest rates may look attractive, they may also be intended to mask the true cost of the loan. Ensure that the full terms of the loan, especially the fees, are available before agreeing to any documents. Shop around and find the terms that best suit your needs. Sometimes, a borrower may be willing to pay more overall for a smaller monthly cost. However, remember that low interest rates and fees may be deceiving and can result in a large, hidden increase in the total cost of a loan, especially if you think prepayment is likely.
See below scenarios that detail the impact of origination fees on effective APR’s by prepayment month:
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Loan specific information included herein is for illustrative purposes only and does not represent actual, real, current, offered, or available loans. Neither this post, nor any attachments, figures, diagrams, nor material otherwise associated with this post constitutes an offer, the availability of, or the suitability of any loan, terms, or actual comparison between or among offered or contemplated loan products. Comparative loan terms, costs, and fees are instrument specific and the models herein included may not cover all possible loan scenarios, models, or possible applications or interpretations of the benefits, costs, or risks of borrowing. SALT policies, rates, fees, and loan availability subject to change at any time at the sole discretion of SALT. All loans are subject to screening, AML, KYC, and suitability requirements and screenings. For additional information, disclosures, restrictions, and limitations please visit, www.saltlending.com.
