Understanding the Cost of Borrowing and How Amortization Works

3 min read


KEY TAKEAWAYS

✔ Cost of borrowing refers to the amount of a loan plus interest and any fees

✔ Various factors affect the cost of borrowing such as the type of loan, the interest rate, how much you borrow and how long your payment term is

✔ Amortization is the process of spreading out a loan over time and over the amortization period your fixed payments change – with more going to interest and less on principal at first and then less on interest and more on principal toward the end.


When you need money, you want to make sure you understand what borrowing money is all about. If you want to borrow $5,000, for instance, it’s not a simple matter of getting someone to loan you $5,000. The cost of borrowing money involves the loan amount plus interest and any associated fees.

There are various factors that affect the cost of borrowing. The type of loan is one. An unsecured personal loan or credit card usually will have a higher interest rate than a mortgage loan. You want to make sure you choose the right type of loan for your borrowing needs.

And, of course, the interest rate on your loan is important. Different lenders have different rates so you want to shop around to find out the best rate you can get. By law, lenders have to tell you what the actual rate of interest charged on a loan each year – or what is called the annual percentage rate or APR. Lenders have to tell you how much interest you’ll pay, if there are any extra fees or charges or if there are any other costs such as loan insurance.

Another factor is the amount of money you borrow. A larger loan takes longer to pay off and will have you pay more interest over time than a smaller loan. The term of your loan is important too. If you get a loan that is paid off over a period of five years as opposed to three years, you’ll pay less on your monthly payments but more in interest overall.

Now, let’s talk about amortization. Amortization is the process of spreading out a loan over a fixed period of time.  So, with a personal loan or mortgage, for instance, your monthly payment would stay the same over a period but your payment is made up of parts that change over time.

Each of your payments goes toward interest (the amount your lender gets paid for lending you the money) as well as principal, which is the amount of your loan. At the start, your interest payments are higher and the amount you pay on the principal are lower, but over time you’ll be paying less in interest and more off the principal amount.

Let’s say you have an unsecured loan of $1,000 at 19.99% interest over a one-year term. At the end of 12 months, you’ll have brought the principal down to zero and, over the course of the year, each of your payments of $92.25 go increasingly more toward principal and less toward interest. In the first month, you’re paying $16 in interest but in the last month you’re paying just $1.45

As you can see, knowing the true cost of your loan is just as important, if not more important, than your monthly payments.

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