How to Understand and Compare Loans… and Choose the Best One

(A CPA’s Financial Advice to Young Adults – Part II)

Introduction

The thoughts below represent the second article in a series, consisting of advice from a CPA to young adults. This series’ goal is to help readers develop good fiscal hygiene, addressing matters that should be, but seemingly are not, consistently taught in high school or even college. Although directed toward young adults, it should be relevant to people of all ages and stages of life.

The first installment, “Let’s Talk about Debt: Your Financial Frenemy” is found on BNN’s website, and it described various purposes of loans (to help you decide whether or not you should borrow money for a particular need). This second installment assumes you have decided a loan is appropriate, and will help you wade through some terminology that may be unfamiliar to you, and allow you to distinguish one type of loan from another. It will arm its readers with the ability to select the right loan and avoid the lousy ones.

The basics

Each loan involves someone borrowing money (the principal) and paying it back to a lender. In exchange for the temporary use of that money, borrowers also pay the lender interest, sometimes combined with fees, in addition to that principal. Interest and fees are how the lender makes money from that loan. There are many creative ways that lenders structure loans, but each one will involve principal and interest. Each one will also involve payment terms, which generally describe how large the payments are, how often they occur, and how quickly the loan will be fully repaid. Some loans involve periodic payments, such as equal amounts due monthly, quarterly, or annually; while others may also involve a disproportionately large payment at the end of the term (a “balloon” payment). Loans may be payable over a short period of time (3-5 years is common for a car loan), or much longer (15-30 years is common for a home loan, known as a “mortgage”). Some involve interest rates that stay fixed over the life of the loan, while others involve rates that vary based on market conditions.

We will describe some of these traits a bit more below, and then explain how you can compare one loan with another, even when the loans have very different characteristics.

Interest – in general

Interest is a charge for the use of money, and it is the primary way lenders make a profit on their loans (without it, they would have little reason to loan money to a stranger). It is usually expressed as a percentage of the loan and it nearly always (but not always) is expressed in annual terms. For instance, if you loan $100 to me for a year, and charge 5% interest, you would expect me to pay you $105 a year from now, consisting of $100 of principal and $5 of interest.

Most often, a loan involves periodic payments of equal amounts. Although the total amount of that payment does not vary, its components do: Each payment consists partly of principal and partly of interest, and with each subsequent payment, the interest portion decreases, and the principal portion increases. This occurs because the interest rate is applied to a smaller remaining loan balance than existed at the beginning of the loan. This allows more of each payment to apply to the principal, causing the remaining payoff amount to decrease at a faster rate near the end of the loan.

Example 1: Your uncle loans you $10,000 to buy an electric upright bass ukulele you need for your hipster punk polka band. You agree on a fixed interest rate of 5% in 3 equal, annual payments. That loan (presented in the form of an “amortization schedule”) would look like this:

Annual Payment
Beginning Principal Interest Principal Total Ending Principal
Year 1 $10,000 $500 $3,172 $3,672 $6,828
Year 2 $6,828 $341 $3,331 $3,672 $3,497
Year 3 $3,497 $175 $3,497 $3,672 $0

Interest: Fixed vs. variable

Interest rates are either fixed or variable, and overlooking this distinction can lead to very costly mistakes, and make one loan appear to be better than another, when in reality it has the potential to be much worse. The terms are pretty descriptive; one type of rate is fixed through the life of the loan, while the other can vary, generally based on national or worldwide market conditions. A common scenario might involve a lender offering you one loan with a fixed rate, or another with a variable rate.

Example 2: A bank offers you a choice of two $10,000 loans. Loan A, with a fixed rate of 5% over a 3 year life, would be identical to what your uncle offered you in Example 1. Loan B, though, offers a variable rate that begins at only 4% for one year, and then changes to 6% for years 2 and 3. Loan B would look like this:

Annual Payment
Beginning Principal Interest Principal Total Ending Principal
Year 1 $10,000 $400 $3,203 $3,603 $6,797
Year 2 $6,797 $408 $3,195 $3,603 $3,602
Year 3 $3,602 $216 $3,387 $3,603 $215

Loan B would leave you with one more payment of $215 (plus interest, if that payment is delayed), or would instead (not presented above) allow you to pay off the loan in three years, but only by increasing the amount of the annual payments in years 2 and 3. Loan B may have looked more favorable with its 4% introductory rate, but it ends up being more costly, due to the higher variable rate in the following years.

The risk of a variable rate loan is that with most of them, the exact amount of the rate increase (if any) is not stated up front, because it is not known, even by the lender. It is instead linked to market rate changes that are unknown at the time. Oversimplifying, the terms may call for something like “interest at 4% for one year, changing to the LIBOR rate + 2% for each year thereafter.” (LIBOR stands for the London Inter-Bank Offered Rate, which is the rate large banks use to lend to one another.)

Variable rates are offered by lenders as a way to allow borrows to enjoy a low rate, but also put the borrower on the hook to share the pain if lending costs increase in the future (banks borrow money too). Fixed rates, by contrast, have a bit of a hedge built into them. Banks know rates might go up, and they cook that possibility into a fixed rate by offering it at a rate somewhat higher than they would offer the starting point of a variable rate. From a bank’s perspective, if lending rates go up, the bank (not you) will absorb the pain if locked into a fixed rate with you.

Fixed and variable rates are routinely used by honest, legitimate lenders. But variable rates have greater potential to be abused by predatory lenders, who might offer an unusually low, temporary stated rate, to be followed by a variable rate that is described vaguely in terms that almost assuredly will result in a steep increase.

For the reasons explained above, you will notice when shopping for a loan that variable-rate loans always offer a lower initial rate than fixed-rate loans. Borrowers may be enticed by low introductory rates offered with variable loans, but need to be prepared for increases in the future.

Observation: Knowing whether to choose a fixed or variable rate is always a bit of a gamble, but if you are working with a budget, a fixed rate offers no unpleasant surprises. Also, at the time this article is being written, interest rates remain historically low (with future movement probably involving an upswing), so many borrowers will fare well (and sleep better at night!) opting for a fixed rate.

APRs: A way to compare apples with non-apples

Lenders are required by federal law to include in their documentation a presentation of their loan’s cost as an “annual percentage rate” (APR). This rate includes not only interest, but also the impact of many types of fees that also must be paid to the lender. Generally the lower the APR, the better, from the borrower’s perspective. The use of APRs (and its inclusion of both interest and fees) helps us compare and contrast different loans.

Example 3: A lender might advertise an interest rate of only 1%, but closer inspection shows that is a monthly rate. Recall, however, that interest almost always is discussed in terms of an annual rate. Instead of misleading you with a too-good-to-be-true offer of 1%, by presenting the APR, that lender would be forced to show that the annual rate is closer to 12%.Example 4: You identify two alternatives for a one-year loan for $10,000. Both seem to promise identical 5% interest rates, but buried in the tiny print, you notice that one is accompanied by a one-time $250 processing fee. Because APRs include the cost of interest as well as fees, it would force that lender to present an APR of 7.5% instead of 5%, and you could quickly see that those two 5% loans were not created equally.

Often the APR will very closely resemble the stated interest rate. If not, be sure to determine why. It usually means that some fees are required, and sometimes those are buried in the fine print. Often the fees are not readily transparent, because they are not paid separately; they instead are simply rolled into the cost of the loan.

Example 5: In example 4 above, you probably would not pay the $250 fee separately, up front. Instead, it would be added to the cost of the loan. In other words, you would really be borrowing $10,250 rather than $10,000.Observation: “Points” are a good example of fees that are added to the cost of a loan. Points are simply additional costs of borrowing money, and are most commonly seen with a mortgage loan related to acquisition of a home. Points do not represent interest, but generally are expressed as a percentage of the amount borrowed. Because they do represent an incremental borrowing cost, they are included in the loan’s APR, thereby continuing to allow the borrower to compare one loan with another.

Fees can’t hide from the APR, so as an informed loan shopper, be sure to snoop for any hidden costs that cause the APR to vary much from the interest rate, or that make one loan’s APR differ significantly from a seemingly similar loan’s APR.

Should I refinance?

Interest rates offered by lenders change all the time. How and why are well beyond the scope of this article, so let’s accept the fact that rates move up and down, and decide whether that can be used to your advantage.

The term “refinance” describes the conversion of an existing loan into a different loan, generally by changing the terms of an existing loan to take advantage of interest rates that are available now that were not available when the loan was first made. Mechanically, it involves a payoff of the first loan using the proceeds of the second loan. It often involves only the remaining principal owed on the first loan (usually increased somewhat by a number of administrative fees), but sometimes it can include a deliberate increase in the loan balance. This allows most of the new loan to be used to pay off the old loan, and a portion of the new loan to be paid in cash to the borrower. The refinancing does not have to be undertaken with the original lender, and it is common for one bank to handle the refinancing, with the result being that they will pay off the first lender, and you will then begin making payments only to the new lender.

A common example of refinancing involves a home mortgage, and the process is started when a homeowner notices that new loans are available with rates lower than he/she is currently paying on an existing loan. If there were no fees associated with undertaking a refinancing, it would be a no-brainer: You should refinance. However, there are going to be fees, consisting of things like closing costs, points, and potentially early prepayment penalties; and the decrease in interest needs to be greater than those costs for it to be worth it for you to refinance.

There really is no shortcut for determining whether refinancing is going to save money for you or not. The best method is to list the total borrowing costs under both methods, and compare the two, preparing amortization schedules for both alternatives. For those who itemize deductions on their tax returns, any tax savings related to the interest payments should be considered as well.

Due to the accompanying fees, small interest rate decreases often are not worth it, unless the loan balance is large or there are many years left on the loan. However, be aware of the potential to refinance, and watch for changes in interest rates so you do not miss an opportunity.

Pulling it all together

Once you have decided a loan is necessary or appropriate, as borrower, you should shop around to find the best terms possible. The biggest variables will be the interest, any fees, the amount and frequency of the payments, and the duration of the loan. Of these, generally the length of the loan is the only variable the borrower can negotiate. Obviously it is paramount that you determine in advance that you can handle the amount of the loan payments, and sometimes extending the life of the loan by a year or so can make the difference.

In comparing loans, the interest and fees deserve a lot of attention, because they represent the true incremental cost of borrowing (the amounts you will pay in addition to the principal that you borrow). As described above, comparing APRs can quickly unmask subtle but meaningful differences between loans that otherwise are hard to see.

Sometimes your financial situation may change for the better, and you are in a good position to pay off a loan early, or make a few payments that are larger than usual. This will lower your overall interest on the loan by reducing the principal early. This generally is allowed, but some lenders want to protect the payment stream associated with lengthy loans, and if you are reducing your loan expenses, they are losing profit. For that reason, some impose a charge for loans that are paid off or down unexpectedly. You should verify up front whether there are any penalties for prepaying the loan.

It is easy to be enticed by a low variable rate, but before abandoning the known comfort (or acceptable level of discomfort!) of a fixed rate, be sure you (1) understand how the variable feature of a variable loan is computed, and (2) can handle the increases, if and when they come.

Our third installment in this series will focus on credit cards (their use, misuse, pros and cons, and other traits that may not be readily apparent), and the existence and significance of your credit rating.

For more information, please contact Stan Rose or your BNN tax advisor at 800.244.7444.

Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.

Keep reading