Taking out a loan can be a pivotal moment in your financial journey, whether you're buying your first home, a new car, or funding other significant expenses. However, it's essential to understand what you're getting into before signing any loan agreement. This article will break down the key elements you need to consider when planning to take a loan.
When you apply for a loan, you will encounter several financial terminologies that might seem confusing. Here are some crucial terms to understand:
Principal/Loan Amount: This is the amount you borrow from the bank.
Repayment Schedule: This outlines how and when you will repay the loan.
How Does Loan Repayment Work?
Repaying a loan involves paying back the principal amount along with the interest charged by the bank. The repayment schedule is typically calculated by the bank and includes monthly instalments that you need to pay over the loan tenure.
Methods of Calculating Loan Interest
Banks use three primary methods to calculate loan interest:
Flat-rate Method: Commonly used for shorter-term loans like car and personal loans, this method charges interest on the entire principal amount throughout the loan tenure.
Amortisation Method: Also known as the reducing balance method, this is used for longer-term loans such as housing loans. Interest is charged on the remaining principal amount, which decreases over time.
Interest-only Loans: These loans require repayment of only the interest charges in the initial years, making them more affordable in the short term.
The True Cost of Borrowing
Many borrowers focus solely on the interest rate and monthly instalments, but the actual cost of a loan is determined by the Effective Interest Rate (EIR). The EIR includes all interest charges and fees, providing a more accurate measure of the loan's cost.
For example, financing a $500,000 property with a 30-year loan at a 5% interest rate using the amortisation method results in interest charges of $466,000. This translates to an EIR of 93.2% of the principal loan amount. Therefore, the total cost of the property would be $966,000 after 30 years.
Factors Affecting Loan Costs
The cost of your loan is influenced by several factors beyond the interest calculation method:
Loan Tenure: The longer the loan period, the more interest you will pay.
Fees and Charges: Additional fees can significantly increase the total cost of the loan.
Making Informed Decisions
Before taking out a loan, it's essential to compare different loan products offered by various banks. Using the EIR as a benchmark can help you understand the true cost of each loan, making it easier to choose the best option for your financial situation.
Taking out a loan is a long-term financial commitment that requires careful consideration and understanding of various factors. By familiarizing yourself with key financial terms, interest calculation methods, and the true cost of borrowing, you can make informed decisions that align with your financial goals.