What is the most important factor you look at before you borrow money? If you are like most people, it is the interest rate. But did you know that relying exclusively on interest rate to determine your best borrowing option is unwise? You need to consider loan terms, too.
There is an intrinsic link between interest rates and loan terms that so many people fail to realize. Believe it or not, terms tend to play a much bigger role in the total cost of borrowing. Why? Because when it comes to borrowing money, time is not on your side.
The Total Cost Principle
The total cost principle can be applied to a variety of things. When applied to borrowing, it constitutes the total amount you will spend to pay back a loan. Take your mortgage. When you bought your home, you borrowed a certain amount. In addition to paying back that amount, you will also pay interest, origination fees, and a host of other fees and charges assessed by your lender. It all adds up to the total cost of borrowing.
Using a typical online mortgage calculator, you can see that the total cost of borrowing $240,000 on a 30-year mortgage at 3.8% works out to more than $504,000. Take out property taxes and insurance (you would pay them even without a mortgage) and your total cost of borrowing drops to about $400,000. That means you are paying $160,000 for the privilege of borrowing.
Longer-Term Equal Higher Costs
According to Salt Lake City-based Actium Partners, a general rule of lending is that longer terms equal higher costs. Actium might make a $500,000 hard money loan at 10% for one year. The total interest payment on that loan would be $50,000. But that same loan offer at 5% for five years would garner interest payments of just over $66,000.
Hard money is an entirely different game altogether. So for the purposes of this post, let’s go back to the $240,000 mortgage. If we leave everything the same, but reduce the term from 30 years to 20, the total cost of borrowing drops to just over $411,000 with taxes and insurance included. Remove taxes and insurance and you’re down to $340,000.
Just by reducing the term by 10 years you end up paying $60,000 less. The interest rate has remained the same. So has your down payment and PMI. The only thing that has changed is the length of the loan. The more quickly you can pay the loan back, the less it will cost you.
Lower Interest Rates
There is another secret that very few people know about. Here it is – lenders are often willing to give borrowers a better interest rate if they are willing to accept a shorter term. On the one hand, this might not make sense in light of the fact that banks make more money on longer terms. But it makes a lot of sense in terms of mitigating risk.
Hard money lenders rarely make loans for longer than 12 months. They keep their loans as short as possible in order to minimize their risk. Banks offer much longer terms, but they also want to manage their risk. A 30-year loan represents a greater risk because there is more time for the borrower to default. A 15-year loan reduces risk by getting the debt paid off more quickly.
The lesson here is simple: there is a strong link between interest rates and terms. If you are looking to borrow, do not choose your lender based solely on interest rates. Consider terms as well.