The Simple Way to Understand the Cost of a Loan

Loans can be confusing.  The salesman throws lots of numbers at you, interest rates, monthly payments, and down payments.  Then he starts using big words and abbreviations you aren’t quite sure you understand.  My APR is 6.2%, amortized over 60 months and that gives me a payment of $456?  What did that guy just say?  If you are confused about loans or the loan process this post will give you a simple way to understand the cost of a loan.

a-simple-way-to-understand-the-cost-of-a-loan

A Loan is a Product

Most people don’t think of loans as products, but that is exactly what they are.  The guy “giving” you the loan, is actually selling you a loan.  He is required by law to tell you all of the numbers and fancy jargon that goes with them, but there is no requirement on how he tells you.  So if you go in to get a car loan, he may give you several options and talk pretty fast while he is doing it.

The market crash of 2008 was largely based on bad loans.  People were shocked someone would give them a loan they couldn’t afford.  Guess what, they didn’t give them loans, they sold them loans.  In my post 10 Surprising Books that Will Change Your Worldview, I mention a book called The Big Short by Michael Lewis.  It gives you a good account of just how ruthless these salesmen are.

It’s More than a Monthly Payment

When you walk up to the loan officers desk the first thing he asks you is “What are you looking at for a monthly payment?”   If he can keep you focused on the monthly payment, you might not notice how much the loan is actually going to cost you.

Here is an example. My husband and I were wandering through Bass Pro Shops a few weeks ago and we were in the boat section.  My husband would really like a boat.  Really, really like a boat. When we found a boat he really liked he pointed to the sign in front of the boat “This one is only $359 a month”. He had a hopeful grin on his face as I moved in closer to the sign.

In really big letters it read “Only $359 a month”.  In smaller letters it told me the price of the boat “$27,000”  and in teeny tiny letters I had to squint at to read it said “12-year loan” Holy crap! 12 years!!  I looked at him and said, “Umm no, these people must be nuts!”  His face fell, but the monthly payment…

The 3 Numbers You Need to Understand the Cost of a Loan

It only takes three numbers to understand the cost of a loan.  You need to know the amount of the monthly payment, you need to know the length of the loan in months and you need to know the purchase price of the item you are purchasing.  That is all you need.   In my boat example, the length of the loan was 12 years or 144 months.  The monthly payment was $359.  Multiply the two and you get $51,696.  Subtract the cost of the boat, $27000, and I know the loan would cost me $24,696.

I repeat the loan would cost me almost as much as the boat itself! 

Bass Pro would kindly give me the loan for the boat for only $359 a month, aren’t they so sweet! Oh yea, and they would make nearly the retail cost of the boat off of the loan.  This is why you always see ads that tell you the monthly payment.  No one wants to tell you “hey that $30,000 vehicle is going to cost you $50,000”

This is why understanding the cost of a loan is so important.  If you know the cost of the loan, you can make a better decision about if you can really afford it or not.

The Formula

Does that word scare you? Formula?  Don’t let it.  Here is what you do; multiply the monthly payment times the months you will pay and subtract the purchase price of the item.  That will give you the true cost of the loan.

Monthly payment x Months you are paying = Total amount you will pay.

Total amount you will pay – Price of item = Cost of the loan.

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Here are a few examples

  • You would like to purchase a $35,000 vehicle, the salesman says $629 a month for 72 months.
    • Monthly payment $629 x 72 months = $45,288, this is the total amount you will pay.
    • $45,288 – $35,000, the cost of the vehicle = $10,288  This is the cost of the loan.
  • You are purchasing a living room suite for $4000 with $99.00 payments for 5 years (60 months)
    • Monthly payment $99.00 x 60 months = $5940, total amount you will pay
    • $5,940 – $4,000 = $1,940, Total cost of the loan

The Take-Away

There are two things I want you to get out of this post.  First I want you to understand a loan is a product.  We all need products, and we expect them to cost money.  Loans are no different.  A loan is a product that costs money.

Second I want you to have a simple way to figure out what a loan will cost you.  The sales man or loan officer will throw lots of numbers at you.  You will look like a brilliant consumer by just using this formula. Bookmark the page if you need to!

Loans are not bad things, but just like you can get a lemon from the car salesmen, you can get a lemon of a loan.  Be ahead of the game and know the total cost before you sign on the dotted line.

 

 

2 Comments

  1. Julie @ Filling the Jars

    September 16, 2016 at 7:08 am

    It always amazes me how many people never do the math when getting a loan! Great post, Michele!

    1. Michele Cook

      September 16, 2016 at 8:36 pm

      Thanks Julie! I think it scares people to do the math, or they don’t feel like they are an adult if they hesitate. I hope this post helps a lot of people

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