Borrowing: What are the Costs of Borrowing Money (15th Blog Post)

Borrowing money is not cost-free. Remember that a lender, otherwise referred to as a creditor, is taking money that belongs to them and allowing you, the borrower, to temporarily use it. For that privilege that they are extending to you, lenders want to be and expect to be compensated.

When you take out a loan, lenders typically charge you “interest” on the loan. The amount of interest you will pay is based on the annual “interest rate” that the lender charges you on the amount of money you have borrowed (otherwise referred to as the “principal” of the loan). For example, let’s say you choose to borrow $1,000 and your lender is charging you a 7.0% “fixed” annual interest rate on your loan. (A “fixed” rate loan is one in which the interest rate charged on the loan does not change during the term of the loan.) In addition to having to pay back the $1,000 of principal at the end of the term of the loan (otherwise referred to as the “maturity date” of a loan), you will have to pay the lender $70 of interest each year (i.e., $1,000 x 7.0%) for the privilege of borrowing the $1,000. Let’s say the loan is a 5-year loan and let’s assume that you are not late in making any of your interest payments during the 5-year period. At the end of 5 years, you are obligated to pay the lender back the $1,000 that you borrowed and you will have paid the lender $350 of total interest (i.e., $70/year x 5 years) for providing you with the loan.

Sometimes lenders will charge borrowers a “variable” annual interest rate on a loan. A “variable” rate loan is one in which the interest rate charged on the loan can change during the term of the loan. The variable rate that is charged on the loan will be driven off of, i.e., linked to, some specific financial benchmark that the lender chooses. If the value of the chosen benchmark declines during the term of the loan, then the variable rate charged on the loan will decline by a comparable amount since the variable rate will be based on a “spread” relative to the benchmark. Conversely, if the value of the chosen benchmark rises during the term of the loan, then the variable rate charged on the loan will rise by a comparable amount. Finally, if the value of the chosen benchmark does not change during the term of the loan, then the variable interest rate charged on the loan will not change. So let’s provide an example for illustration purposes.

Let’s say you choose to borrow $1,000, your lender charges you initially a 7.0% “variable” annual interest rate on your loan, and the loan has a 5-year term. Let’s additionally assume the following: 1) the average value of the financial benchmark, to which the loan’s variable annual interest rate is linked, is 3.50% in year 1 and then the average value of the benchmark increases by 0.25% in both years 2 & 3 and decreases by 0.50% in both years 4 & 5; and 2) the “variable” annual interest rate on the loan is equal to a spread of 3.50 percentage points over the value of the financial benchmark to which the loan is linked.

	Year 1	Year 2	Year 3	Year 4	Year 5
Average Value During the Year of the Financial Benchmark to Which Your Variable Interest Rate Loan is Linked	3.50%	3.75%	4.00%	3.50%	3.00%
Year-over-Year Change		​+0.25%	+0.25%	-0.50%	-0.50%
Average Variable Annual Interest Rate Charged on Your Loan During the Year (the Averages for Years 2 through 5 are Implied Averages)	​7.00% (i.e., a 3.50 percentage point spread over the benchmark)	7.25%	7.50%	7.00%	6.50%
Implied Year-over-Year Change		​+0.25%	​+0.25%	-0.50%	-0.50%
Implied Amount of Interest You Owe on Your Loan Each Year	​$70.00 (i.e., $1,000 x 7.00%)	$72.50 (i.e., $1,000 x 7.25%)	$75.00 (i.e., $1,000 x 7.50%)	$70.00 (i.e., $1,000 x 7.00%)	$65.00 (i.e., $1,000 x 6.50%)
Implied Year-over-Year Change		+$2.50	+$2.50	-$5.00	-$5.00

Implied Total Amount of Interest Owed by You over the 5-Year Term of the Loan, Assuming that You are Not Late in Making Any of Your Monthly Interest Payments During the 5-Year Period	Over the 5-year term of the loan, you owe $352.50 (i.e., $70.00+$72.50+$75.00+$70.00+$65.00) in interest expense
Total Amount of Money You are Obligated to Repay the Lender at the End of 5 Years, Assuming that You are Not Late in Making Any of Your Monthly Interest Payments During the 5-Year Period	​At the end of the 5-year term of the loan, you must repay the $1,000.00 that you borrowed (otherwise referred to as the “principal” of the loan)

You will notice that one of the assumptions in our examples of both a fixed rate loan and a variable rate loan is that you are not late in making any of your interest payments during the term of the loan. This is an important assumption. Why? Because lenders typically charge borrowers what are commonly called “late fees” if they fail to make their interest payments on time. The late fee, a type of penalty, is generally added to the outstanding balance of your loan, thereby increasing the outstanding balance of your loan. And, of course, the fixed rate or variable rate that the lender charges on your loan is charged on the outstanding balance of your loan, which represents the total amount of money you are obligated to repay the lender at the end of the term of the loan. Late fees are one of the ways in which lenders make money through issuing loans.

Let’s illustrate the math of late fees assuming the size of an individual late fee you are charged on a loan is $35.00. For simplicity, we will also assume in our example the following: 1) the amount you borrow, once again, is $1,000; 2) other than the months in which you incur late fees, you make all other monthly interest payments during each of the given years on time; and 3) you do not repay any of the outstanding balance of your loan (which includes the principal of the loan + the late fees that are added to the outstanding balance) during the 5-year term of the loan, instead waiting until the end of the term to fully repay it.

	Year 1	Year 2	Year 3	Year 4	Year 5
Size of Individual Monthly Late Fees Charged by Your Lender	$35.00	$35.00	$35.00	$35.00	$35.00
# of Monthly Late Fees You are Charged During the Period	2	3	4	1	5
Implied Total Amount of Late Fees You are Charged During the Period	$70.00 (i.e., $35.00 x 2)	$105.00 (i.e., $35.00 x 3)	$140.00 (i.e., $35.00 x 4)	$35.00 (i.e., $35.00 x 1)	$175.00 (i.e., $35.00 x 5)
Implied Outstanding Balance of Your Loan at the End of the Period, Assuming You Have Made All Other Interest Payments During the Period on Time and Assuming You Do Not Repay Any of the Outstanding Balance of the Loan Prior to the End of the Term of the Loan	$1,070.00 (i.e., $1,000 + $70)	$1,175.00 (i.e., $1,070 + $105)	$1,315.00 (i.e., $1,175 + $140)	$1,350.00 (i.e., $1,315 + $35)	$1,525.00 (i.e., $1,350 + $175)
Implied Cumulative Change (in Dollars) in the Outstanding Balance of Your Loan at the End of the Period, Assuming You Have Made All Other Interest Payments During Each Period on Time and Assuming You Do Not Repay Any of the Outstanding Balance of the Loan Prior to the End of the Term of the Loan	+$70.00 (i.e., $1,070 - $1,000)	+$175.00 (i.e., $1,175 - $1,000)	+$315.00 (i.e., $1,315 - $1,000)	+$350.00 (i.e., $1,350 - $1,000)	+$525.00 (i.e., $1,525 - $1,000)
Implied Cumulative Percentage Change in the Outstanding Balance of Your Loan at the End of the Period, Assuming You Have Made All Other Interest Payments During Each Period on Time and Assuming You Do Not Repay Any of the Outstanding Balance of the Loan Prior to the End of the Term of the Loan	+7.0% (i.e., $70 / $1,000)	+17.5% (i.e., $175 / $1,000)	+31.5% (i.e., $315 / $1,000)	+35.0% (i.e., $350 / $1,000)	+52.5% (i.e., $525 / $1,000)

As you can see in this example, the negative impact of late fees on what you owe on a loan can be substantial. In our example, the amount that you would be obligated to repay the lender at the end of 5 years increased 52.5% from $1,000 to $1,525. That is a large increase! And this is just due to the cumulative impact of late fees on your loan.

Now let’s tie together the analysis above, of the impact of late fees on the total amount of money you are obligated to repay the lender at the end of the term of the loan, to an analysis of the impact of late fees on the total amount of interest you will owe on your loan over the full term of the loan. In this example, we will assume that the loan is a variable rate loan (using the same variable rates as we used in the analysis above) although the basic math would work similarly if we assumed that the loan was a fixed rate loan. And for simplicity, we will again assume the following: 1) the amount you borrow is $1,000; 2) other than the months in which you incur late fees, you make all other monthly interest payments during each of the given years on time; and 3) you do not repay any of the outstanding balance of your loan (which includes the principal of the loan + the late fees that are added to the outstanding balance) during the 5-year term of the loan, instead waiting until the end of the term to fully repay it.

	Year 1	Year 2	Year 3	Year 4	Year 5
Size of Individual Monthly Late Fees Charged by Your Lender	​$35.00	$35.00	$35.00	$35.00	$35.00
# of Monthly Late Fees You are Charged During the Period	2	3	4	1	5
Implied Total Amount of Late Fees You are Charged During the Period	​$70.00 (i.e., $35.00 x 2)	$105.00 (i.e., $35.00 x 3)	$140.00 (i.e., $35.00 x 4)	$35.00 (i.e., $35.00 x 1)	$175.00 (i.e., $35.00 x 5)
Outstanding Loan Balance at the Beginning of the Period	$1,000.00	$1,070.00	$1,175.00	$1,315.00	$1,350.00
Outstanding Balance of Your Loan at the End of the Period, Assuming You Have Made All Other Interest Payments During the Period on Time and Assuming You Do Not Repay Any of the Outstanding Balance of the Loan Prior to the End of the Term of the Loan	$1,070.00 (i.e., $1,000 + $70)	$1,175.00 (i.e., $1,070 + $105)	$1,315.00 (i.e., $1,175 + $140)	$1,350.00 (i.e., $1,315 + $35)	$1,525.00 (i.e., $1,350 + $175)
Implied Average Outstanding Balance of Your Loan (Roughly[1]) During the Period, Assuming You Have Made All Other Interest Payments During the Period on Time and Assuming You Do Not Repay Any of the Outstanding Balance of the Loan Prior to the End of the Term of the Loan	$1,035.00 (i.e., [$1,000 + $1,070] / 2)	$1,122.50 (i.e., [$1,070 + $1,175] / 2)	$1,245.00 (i.e., [$1,175 + $1,315] / 2)	$1,332.50 (i.e., [$1,315 + $1,350] / 2)	$1,437.50 (i.e., [$1,350 + $1,525] / 2)
Average Variable Annual Interest Rate Charged on Your Loan During the Period	​7.00%	7.25%	7.50%	7.00%	6.50%
Implied Amount of Interest You Owe on Your Loan Each Period (Roughly[2])	$72.45 (i.e., $1,035.00 x 7.00%)	$81.38 (i.e., $1,122.50 x 7.25%)	$93.38 (i.e., $1,245.00 x 7.50%)	$93.28 (i.e., $1,332.50 x 7.00%)	$93.44 (i.e., $1,437.50 x 6.50%)

Implied Cumulative Amount of Interest You Owe on Your Loan over the 5-Year Term of the Loan (Roughly)	Over the 5-year term of the loan, during which you incurred late fees, you owed roughly $433.93 (i.e., $72.45+$81.38+$93.38+$93.28+$93.44) in interest expense
Cumulative Amount of Interest Owed by You over the 5-Year Term of the Loan Assuming No Late Fees	Over the 5-year term of the loan, you owed $352.50 in interest expense since you did not incur any late fees
Implied Cumulative Impact (in Dollars) of Late Fees on the Total Amount of Interest Owed by You over the 5-Year Term of the Loan	Over the 5-year term of the loan, you owed roughly $81.43 in additional interest expense (i.e., $433.93-$352.50) because of the imposition of late fees
Implied Cumulative Percentage Impact of Late Fees on the Total Amount of Interest Owed by You over the 5-Year Term of the Loan	Over the 5-year term of the loan, you owed roughly 23.1% additional interest expense (i.e., $81.43 / $352.50) because of the imposition of late fees

As you can see in this example, the negative impact of late fees on the total amount of interest you owe on your loan also can be substantial. In our example, the total amount of interest you would owe on your loan over the 5-year term of the loan increased by nearly 25% because of the impact of late fees. Again, that is a large increase and one that is just due to the cumulative impact of late fees on your loan.

Lenders commonly require interest payments be made on a monthly basis. (So, in practice, a borrower is typically required to pay each month 1/12 of their annual interest expense obligation.) Late fees on those payments can add up and accumulating them can cost a borrower a lot of money over time as well as negatively impact their credit history and “credit scores”. (When borrowers miss payments, lenders report the missed payments to credit reporting agencies who collect, analyze and report such data to lending institutions broadly. Lenders also continue to update credit reporting agencies on the length of time that a borrower’s missed payments are overdue.) A borrower’s credit score is a quantified indicator of that individual’s creditworthiness, i.e., an indication of how likely is it that the individual will be able to make interest payments owed on loans and repay the principal of loans. A borrower’s credit score -- which is influenced, among other factors, by one’s credit history[3] including one’s loan payment history -- impacts the lending decisions of lenders, including whether to even make a loan to the given consumer in the first place and how much to lend and what interest rate to charge in the event they are willing to issue a loan.

The bottom line is that you have to be extremely careful when you decide to borrow money. If you are going to borrow money, it is in your financial self-interest both to make your interest payments on time and to repay your loan on time.

It is also important to realize that lenders potentially may charge you other types of fees besides just interest and late fees. While the types of fees lenders charge can vary by type of consumer loan, some of the more common examples to be aware of include:

At the end of the day, the fees lenders charge can come in many forms and can add up. They can cost a borrower a lot of money. We previously mentioned that the decision to take on personal debt is a major personal decision and an enormously important one to fully think through before borrowing money. As part of any decision to take out a loan, it is prudent to compare and contrast the offerings of multiple lenders and to carefully review the various costs that you will incur and potentially could incur. It is critically important to make as fully educated and informed a decision as possible. Furthermore, if one takes on debt and it is high-cost debt (i.e., high interest rate debt) like credit card debt, paying it off as quickly as possible can be one of the best personal financial decisions one makes. Why? Because the interest payments one makes on outstanding debt eat into one’s consumption capacity. In other words, they eat into how much you as a consumer can spend on anything else.

I would love to hear from you. Any ideas, experiences, thoughts, comments and questions….please do share.

[1] “Roughly” because, in reality, the timing of when exactly during a given year late fees are incurred and added to the outstanding balance of one’s loan matters, since the timing will impact the calculation of the average outstanding balance for the year as a whole. As an example, if late fees are added to the outstanding balance of the loan in the first two months of the year and you do not repay any of the outstanding balance during the remainder of the year, then the average outstanding balance of your loan for the full year will be higher than if late fees are added to the outstanding balance of the loan in the last two months of the year. The reason is because you would end up carrying a comparatively larger outstanding loan balance throughout the vast majority of the year in the former scenario and a comparatively smaller outstanding loan balance throughout the vast majority of the year in the latter scenario.

[2] “Roughly” because, in reality, the amount of interest you owe on a loan will be calculated on a monthly basis, not on an annual basis. So the timing of when exactly during a given year late fees are incurred and added to the outstanding balance of one’s loan matters, since the timing will impact the actual amount of interest you end up owing on your loan for the full year. As an example, if late fees are added to the outstanding balance of the loan in the first two months of the year and you do not repay any of the outstanding balance during the remainder of the year, then the amount of interest you will owe on your loan for the full year will be higher than if late fees are added to the outstanding balance of the loan in the last two months of the year. The reason is because you would end up carrying a comparatively larger outstanding loan balance (on which you would be charged interest) throughout the vast majority of the year in the former scenario and a comparatively smaller outstanding loan balance (on which you would be charged interest) throughout the vast majority of the year in the latter scenario.

[3] A consumer’s credit history is officially captured, and made available to lending institutions, by what are called in the United States “credit reporting agencies” or “credit bureaus”. A person’s credit history includes, for example, their loan payment history, their total outstanding debt, the types of credit they have received, the length of their credit history, whether any lenders have the legal right to take ownership of and sell assets that the person has used as “collateral” for any current outstanding loans, and whether the person has had any personal bankruptcies and/or legal judgements issued against them that may be relevant to their credit history. “Collateral” represents something that has been pledged by a borrower to a lender in the event the borrower defaults on the loan that they received. An example of collateral is a home in the case of a home loan and a car in the case of a car loan. If a borrower fails to repay a home loan or auto loan that they received, then the lender may have the legal right to take ownership of and sell that borrower’s home or car. Lenders like collateral because it helps protect them against taking a loss (through hopefully recovering the full amount of the loan and perhaps interest owed as well) in the event a borrower defaults on a loan.

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