How Borrowing Really Works

The story: Marcus and two car loans

Marcus stands at a car lot comparing two loan offers for the same car, one with a smaller monthly payment.

1. Narrator: Marcus needs a car to reach job sites. The lot offers two loans for the same car.
2. Marcus: Loan A is $470 a month. Loan B is only $263. B looks easier on my budget.
3. Narrator: Both borrow $15,000 at the same example rate, 8% APR. Loan B just takes twice as long to pay back.
4. Marcus: So what do I pay in total?
5. Narrator: Loan A totals about $16,920. Loan B totals about $18,940. The smaller payment costs about $2,000 more.
6. Marcus: The monthly number was hiding the real price.
7. Narrator: The real price of a loan is the total you pay back, not the monthly payment.

What you’ll learn

1. Principal, interest and term

   Principal is the amount you borrow. Interest is what the lender charges for it. The term is how long you have to pay it back. Each monthly payment covers some interest and some principal.

2. APR is the yearly price tag

   APR (annual percentage rate) is the yearly cost of borrowing, including some fees. APY is different: it shows what savings earn in a year. Comparing APRs is a quick way to compare loans for the same amount and term.

3. Longer term, lower payment, bigger total

   Stretching a loan over more months makes each payment smaller, but you pay interest for longer. Two loans with similar payments can cost very different totals, so the total is the number to compare.

   Example: $15,000 at 8% APR costs about $1,920 in interest over 3 years and about $3,940 over 6 years.

4. Early payments carry the most interest

   Interest is figured on what you still owe. At the start you owe the most, so more of each payment goes to interest. As the balance drops, more goes to principal. This payment schedule is called amortization.

   Example: on $15,000 at 8% APR over 6 years, $100 of the first $263 payment is interest.

Key words

principal

the amount you borrow, before interest

APR

the yearly cost of borrowing, including some fees

Also called: annual percentage rate

term

how long you have to pay a loan back

amortization

the schedule that splits each payment between interest and principal

Common questions

Is a lower monthly payment ever the better choice?

It can be, when a budget truly needs the room each month. Here’s how many people decide: compare the totals, then pick the shortest term whose payment still fits.

Does paying extra help?

On most loans, yes. Extra money goes to principal, so later interest is figured on a smaller balance. It’s worth checking that the loan has no prepayment penalty.

Remember this

The real price is “how much in total?”, not “how much a month?”

Try it: Find the total on one real debt

1. Pick one loan or card you have, or use the car loan from this lesson.
2. Find its balance, APR and monthly payment.
3. Use the Loan Payment Calculator or Loan Payoff Calculator to see the total interest and the payoff date.

Loan Payment Calculator or Loan Payoff Calculator with one real debt.