You are looking to borrow a sizable amount of money. Maybe you’re hoping to purchase that first home or are wanting to get into real estate investing. As you begin shopping around, what is the first thing you look at on new loan offers? Most people look at either the base interest rate or the APR (annual percentage rate).
This mystifies me. Why? Because a loan’s interest rate is just one factor that goes into determining the total cost of borrowing. And for my money, the total cost of borrowing is a lot more important. It tells the whole story while interest rate only tells one small part of it.
Let’s Define Some Terms
In order for me to fully explain my point, I need to first define some terms. Here are three key definitions:
- Interest Rate – The amount of interest a borrower pays on the principle, expressed as a percentage of the total at the start of each loan year.
- APR – The combined interest, fees, and points paid every year, based on a percentage of the total amount outstanding.
- Total Cost of Borrowing – The total amount a borrower pays for the privilege of borrowing, over the entire life of the loan in question.
Total cost of borrowing is more important to me because it accounts for every penny I pay as a result of borrowing money. It includes interest, any fees associated with originating the loan, underwriting fees, and even things like prepayment penalties. I want to know the total amount I will be spending when everything is said and done.
Why It Matters
The total cost of borrowing matters to me because interest rates and APRs can be misleading. Take hard money lending as compared to conventional financing. According to Actium Partners, a Salt Lake City hard money lending firm, hard money loans typically come with interest rates that are a couple of points higher than their conventional counterparts.
This is one of the chief criticisms of hard money lending. But interest rate alone does not tell the whole story. If I am going to figure out the total cost of borrowing, I need to factor in loan terms. In other words, how long will I be paying off the loan.
If I have a short-term hard money loan that will be paid off in 24 months, I will only be making interest payments for that same amount of time. But if I take out a conventional loan with a 30-your term, I will be paying interest for 30 years.
Even if the interest rate on the hard money loan is two points higher than its conventional counterpart, the 24-month term will mean I will pay less in total interest. When everything is said and done and the loan is paid off, I will have spent less money on the hard money loan despite its interest rate being two points higher.
You Have to Consider Everything
Of course, my scenario relies on all other things being equal. That rarely happens, but the main point still applies. Interest rate alone does not tell the whole story. I need to consider every expense to fully understand how much I will pay to borrow.
Interest rate is important when I go shopping for loans. But I use it as my starting point only. I also look at every other expense with the goal of understanding the total cost of borrowing. My final decision almost always directs me to the loan with the lowest total cost. That way, I spend only what is absolutely necessary.