Loans can be confusing, even after you’ve read all of the fine print and crunched all of the numbers. To make it simpler, let’s break a loan down into four main components: principal, interest, collateral, and term.
The Principal is the sum of money that you originally borrowed.
Interest is the lender’s charge for use of the money. To a lender, a loan is an investment, and the interest is the return. It’s better to shop around to see if you can get a better interest rate, especially for mortgages.
There are two types of interest rates: fixed and variable. Fixed rates are, unsurprisingly, unchanging. Variable rate can change over time, based on the prime rate or another rate called an “index.” With a variable-rate loan, the interest rate on the loan changes as the index rate changes, meaning that it could go up or down.
Loans are either secured or unsecured. A secured loan has collateral, such as your car or house, which makes it less risky for the lender. An unsecured loan doesn’t require collateral from the borrower and usually has a higher interest rate.
The term of the loan is the length or life of the loan. For example, mortgages are typically 30 years and student loans are usually 10 years.
Let’s break it down!
Say you have an unsecured loan of $10,000 with a fixed interest rate of 5.25% and a 10-year term. In order to pay off the loan in 10 years, you’ll have to make a monthly payment of $107.29. Your monthly payment goes to interest first and then to your principal. After making all of your payments on time over the 10 years, you’ll end up paying $12,875 total: $2,875 in interest, plus the $10,000 you initially borrowed.
Want to know how we got those numbers? You’re in luck because there are a lot of loan calculators out there. We especially like NerdWallet’s simple student loan calculator*, you can use to calculate the cost of any loan if you know the principal, interest rate, and term.
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