How Personal Loan Interest Works

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It has always been common practice to save for the rainy days but sometimes these days come sooner than we expect them to. An accident or a broken home appliance could send you cracking open that poor piggy bank and digging for coins under the couch. Fortunately, there’s a way to mitigate this and that’s getting a personal loan from a bank.

What is a personal loan? 

A personal loan is when you borrow money to pay for personal expenses like a vacation, home renovations, or medical bills. You will then pay the money back in a fixed amount per month called an installment payment. The time frame given to you will depend on the amount you borrowed but it usually ranges between 12-120 months. A fee will also be charged to pay the bank for borrowing money which is called interest. 

There are many different types of loans which range from personal loans to mortgages. You might be wondering about the differences between each one. Here is a summary on the four most common types of loans.

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Table of Contents

 Loan MaximumTerm LengthsSecured or Unsecured
Personal Loans

$25, 000 to $50, 000 for unsecured loans 

 

$250, 000 for secured loans

Up to 10 yearsBoth
Student Loans$12, 500 annuallyVaries depending on debt and post- graduate incomeUnsecured
Auto Loans$100,0002- 7 yearsSecured
Mortgages$420,00015- 30 yearsSecured

 

The biggest differences among them is the purpose of the loan, the amount of money you can borrow, and the time you are given to pay it back. For example, with a student loan you can borrow up to $12,500 and the time given to pay back the money will depend on your post graduate salary. 

This is smaller in comparison to a personal loan but the time frame, interest, and the amount you need to pay per month is more forgiving. Secured loans also require collateral or a property of value to minimize risk for the lender. This is a good example of why it is important to identify the purpose of your loan before getting one. 

Personal loans do have an edge in terms of its versatility. Most lenders would allow you to use your loan on any legal purpose; be it shopping or a dream wedding. You also do not have to offer collateral in order to receive funds. Another advantage is its lower interest rates compared to credit cards. Lastly, personal loans can easily be lent despite having a low credit score. 

However, these loans also have their drawbacks. Despite having a lower interest rate than credit cards, they have a higher interest rate than secured loans. Which means you might pay interest up to 30%. This is especially true if you have a low credit score. There are also fees and penalties such as the origination fee which covers the cost of processing the loan. 

Another fee to look out for is the prepayment or early payment fee which is charged to cover for the interest that they would have collected if your loan had matured.

But how is the interest computed? 

We first need to gather all the information necessary which is your principal loan amount, interest rate, and total number of years to pay. We then plug these values into a formula:

  1. A = P(1+rt) wherein P is the principal, r is the interest rate, and t is time in years

  2. For this example our principal is $15,000, our interest rate is 5% (0.05 in decimal form), and our time is 5 years.

  3. A = 15,000(1+0.05*5)

  4. A = $18,750

  5. The $18,750 is the total amount you will pay back to the bank with interest. Note that some fees and penalty charges may affect the final amount you end up paying.

You’re probably thinking about how easy it is to just get a loan and start going on a shopping spree but you have to remember that loans are not just easy cash but also a form of debt. If you already know about your own spending habits, then you can easily evaluate whether or not you have the discipline and the capacity to pay back a loan. 

You also have to think about your salary and your already existing monthly expenses. You have to be sure that you’d still be able to pay for your utility bills and monthly groceries along with the loan you took out. 

With this in mind, it is always important to first take a step back and think about your financial situation and the purpose and urgency of the loan. It might end up being a better choice to use a credit card instead of a loan especially if you have a low credit score. The interest rate may be higher, but credit cards usually offer more flexible repayment terms. 

You may also opt for a home equity loan where you can use the equity of your home as collateral. The loan amount will be determined by the value of your property – of which an appraiser will determine.

The bottomline is that incurring more debt that you could handle could lead to serious consequences that might be difficult to get out of. Before deciding to get a personal loan, try making a budget spreadsheet to see how your finances will fare when you start paying. Before signing, make sure to read the document very carefully, especially the fine print, in order to avoid penalties in the future.

Once you do get a loan, make sure to set your payment schedule to what works best with your budget. Depending on your other bills, you may want to schedule your due date in the middle or the end of the month. Automating your payments also makes it more convenient for you and allows you to save money on late fees. 

Remember to borrow only what you need, know how much you can afford, and monitor your cash flow.

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