Personal Finance

Are You Planning To Take A Loan? Read This To Know What You Are Getting Into

Buying your first house or car can be an exciting moment in life. It is like achieving a significant milestone because you can financially afford to buy something of substantial value.   In truth, even though you have saved up enough money to pay for the down payment of a house or a car, you still need to borrow from the bank to afford them.  Most people save up to 10 to 20% of the purchase value and apply for a loan to finance the remaining amount. Because houses and cars are expensive purchases, the loan amount is large and takes a longer time to pay off.  Hence, taking up a loan is a long-term financial commitment, and you must be clear about what you are getting into. Here are some important points that you need to know before you sign the loan agreement. Understanding banking terms and how loans work?  When you apply for a loan, many financial terminologies can sound confusing. Here are some important bank loan terms to know.  Principal/Loan amount - the amount you borrow   Interest - what you pay the bank to borrow money and it is based on the agreed interest rate  Interest rate - the annual percentage rate (APR) that the bank charges for the loan  Loan period/Tenure - the number of months/years for you to pay back the loan  Repayment schedule -   Instalment - the monthly amount that you need to repay to the bank   Effective interest rate (EIR) - the total loan cost percentage  Fees - other costs of taking out a loan, such as origination fees, late fees, insufficient funds fees and more  How does loan repayment work?  When you borrow money from the bank, you need to repay the amount you borrowed, and the interest charged for the loan. Every month you repay the bank the agreed amount based on the repayment schedule calculated by the bank.  How is loan interest calculated, banks use these three methods  There are three methods that banks use to calculate loan interest charges.   One is the flat-rate method, commonly used for calculating shorter-term loans such as car and personal loans.   The second is the amortisation method (also known as reducing/diminishing balance) for longer-term loans such as housing loans.   And the third, to make loans more affordable, banks offer interest-only loans that only require repayment of interest charges in the first years.Same principal amount but a different cost of borrowing  The method used to calculate the loan interest charges decides the cost of your borrowing.  Flat-rate method loans are the most expensive while amortised loans are the cheapest of the three. So, before you sign up for a loan, check with the bank which method is used to calculate the loan you want to take up. The total cost of your loan is different from the interest rate that you pay  When applying for a loan, most people only focus on the interest rate that the bank charges and the monthly instalment they need to pay.   Few people know how loan interest charges are calculated and the actual cost of their loans. The actual cost of loans is the loan’s Effective Interest Rate (EIR). The EIR is the percentage of total interest charges and fees paid for the loan.   Knowing the loan’s EIR is the most important thing for borrowers because EIR measures: -  The feasibility of the loan. For example, a $500,000 property financed using a 30-year loan with an interest rate of 5% pa, calculated using the amortisation method will cost you interest charges of $466,000. This translates into an EIR of 93.2% of the principal loan amount (we have not added the loan fees yet). What it means is that when you finish repaying the loan in 30 years, your property will cost $966,000.  The cost of the loan. It is a useful tool when comparing loans offered by the various banks. When shopping for a loan, it can be confusing when banks offer different interest rates, tenures, and fees for loans. But with the EIR as a benchmark, you can easily compare the costs of the loan products in the market and not just decide based on the interest rate offered. Other factors that can affect your loan cost  The actual cost of your loan depends not only on the method of interest calculation but also on the term of your loan (time is money). The longer the loan tenure, the more interest will be charged on your loan.