Understanding The Cost Of Borrowing
When money is borrowed, there are interest rates and fees attached to the agreement. This is how the lender makes a profit.
But this means that you will almost always pay back more than you borrowed in the first place.
Comparing different borrowing products can be complicated, and it is important to fully understand the true cost involved.
How To Compare Costs
Look for mentions of interest rates, whether they’re fixed for a certain period, and any fees – such as a balance transfer fee or an early repayment charge. These are the main factors to consider, and they affect the calculation.
You will also want to have a think about how much you can reasonably repay per month. It may be that the best deal on offer would expect you to repay loads every month, but if this is beyond your budget then you’ll have to pick a different loan product.
Finally, the length of the loan itself will affect how much you look to repay – and you’ll have to factor in how the interest may accumulate as you’re paying it off.
Here’s an example -
James needs to borrow £1,000 to replace his old boiler.
He gets a quote from a big energy company for the boiler and the installation, including paying back the cost over two years. However, when he reads the contract, he notices that if he takes out their credit for two years, he will pay more than £300 in interest.
He considers his alternatives:
- He could apply for a personal loan with an interest rate of 10% that he can pay back over two years.
- He could take out a credit card with an introductory interest-free period of 15 months on new purchases.
This is a demonstration of his possible costs each month and overall:
| Option | Interest rate | Monthly repayment | Total amount repayable |
|---|---|---|---|
| Credit card over 15 months | 0% | £66.67 | £1,000 |
| Personal loan over 24 months | 10% | £46.14 | £1,107 (£1,000 borrowed + £107 interest) |
| Energy company credit agreement over 24 months | 30% | £55.91 | £1,342 (£1,000 borrowed + £342 interest) |
James decides that putting the purchase on a credit card with a suitable introductory offer is the cheapest overall option, although he’ll have to pay back £10.76 more each month than the Energy company offered. He’ll also be out of debt quicker – at 15 months rather than 24 – and won’t have paid any interest on the loan.
James will only save money because he knows he can make the payments on time. If you don’t think you would be able to do that, a credit card would cost you more.
You can also use an online calculator like this one to see how interest rates and the duration of the loan affects the overall cost.