Why Cheaper Interest Rates Don’t Always Mean You Pay Less for a Loan

Why Cheaper Interest Rates Don’t Always Mean You Pay Less for a Loan

22 March 2024

Securing a loan for your next leisure purchase comes with many considerations, with the interest rate often becoming the focal point of the decision-making process. You might think the most important thing to look at is the interest rate – the lower the better, right? But it’s not that simple.

Factors such as loan terms, fees, and other charges playing pivotal roles in the true cost of a loan. This complexity suggests that the impact of interest rates on loan repayments might not be as significant as many think, as a lower interest rate doesn’t always mean you’ll pay less over the life of your loan.

Understanding Interest Rates

Interest rates are essentially the cost of borrowing money. They are expressed as a percentage of the principal loan amount and can be fixed or variable. While it’s true that a lower interest rate can reduce the amount of interest you pay, it’s not the only factor that determines your overall loan repayment.

The Role of Loan Terms

The term of your loan, or the repayment period, plays a significant role in determining your monthly repayments and the total interest paid over the life of the loan. Extending the loan term can lower your monthly payments but increase the total interest paid. Conversely, a shorter loan term means higher monthly payments but less interest over time.

Let’s illustrate this with an example:

  • Loan A: $20,000 at a 5% interest rate over 10 years. Roughly $5,500 total interest*.
  • Loan B: $20,000 at a 4% interest rate over 15 years. Roughly $6,600 total interest*.

At first glance, Loan B might seem more attractive due to the lower interest rate. However, the extended term means that, overall, you could end up paying more in interest compared to Loan A, despite the lower rate.

The Impact of Fees

Another aspect to consider is the fees associated with taking out a loan. Set up fees, application fees, account keeping fees and other charges can add up, affecting the total cost of your loan. Sometimes, loans with slightly higher interest rates may offer lower fees, making them a more cost-effective option in the long run.

The below table illustrates the differences between two different loan structures, with alternate interest rates and account keeping fees. While Loan B offers a lower interest rate, the overall repayment is higher due to additional fees. Loan A’s fees have been built into the interest rate, meaning there are no extra surprises when it comes to repayments. The table also shows how the loan amount can considerably impact your repayment, making higher deposits more favourable.

 Loan Amount $80,000Loan Amount $90,000Loan Amount $100,000
Loan A Weekly Payment @ ie. 7.99% with no account keeping fees (true weekly repayments)$293$329$365
Loan B Weekly Payment @ ie. 6.99% with account keeping fees of $13 per month$308$346$384

Borrowers often fall into the trap of focusing solely on securing the lowest interest rate possible, overlooking other crucial elements like loan term and fees. A lower rate can indeed save you money on interest, but when paired with a long loan term, the savings can be offset by the increased interest accrued over time. Moreover, if lower interest rates lead you to choose a loan with higher fees, the initial savings can quickly be nullified. Therefore, it’s essential to consider all aspects of a loan, not just the interest rate.

A useful figure to look for when assessing loans is a comparison rate, a tool designed to help borrowers understand the true cost of a loan by combining the nominal interest rate with most of the loan’s upfront and ongoing fees. This rate is expressed as a single percentage figure, making it easier to compare the total cost of different loan products side-by-side. It’s a better reflection of the cost of a loan than solely the interest rate.

When evaluating loan options, it’s important to look beyond the interest rate. Consider the term of the loan, any associated fees, and the comparison rate. Use Set Up Finance’s free loan calculator to compare different scenarios and understand how changes in interest rates, loan terms, and fees can impact your total repayment amount. At Set Up Finance, we can help you demystify the often confusing world of loans and repayment options, and advise you on the best loan for your specific needs.

Low-interest rates are tempting, but smart borrowers know to look at everything involved with the loan. By understanding all parts of the loan, like the length of time you have to pay it back, the fees, and the comparison rate, you can make a better choice for your money. The best loan for you is one that has a good balance of a fair rate, a reasonable time to pay it back, and low fees.

*Approximate figure. Calculated with regular repayment schedule and no additional repayments.

Before deciding, chat to our expert and friendly team to explore your options based on your unique financial situation and long-term goals. Remember, the right financing choice can make a significant difference in your financial health and how quickly you achieve your dream life.