Money and You: Course Notes

When you borrow money, the amount that you borrow is called the principal. It is the base amount that you need to pay back. As you repay your loan over time, some of your payments will go toward what you owe (the principal) and reduce that amount. Once you pay back the entire principal amount, you have repaid the loan.

At any moment in time, the amount you owe on a loan is your balance. As you make payments on your loan, the balance of your loan (usually) decreases. Once your balance has reached $0, you will have paid off your loan and don’t owe any more payments. For example, suppose you take out a loan of $1,000. The principal on your loan is $1,000, and that is your balance. Suppose that your first payment is $250 where $200 “goes toward the principal” and $50 is interest/fees. Then after the payment, your balance drops to $800.

Here is an important thing about balances. Your balance will increase if you don’t make payments. This is because of interest. Take the last scenario where you had $50 in interest. If you didn’t make that $250 payment, your balance would have increase to $1,050 (the $1,000 previous balance plus the $50 in interest). As we’ll discuss next, higher balances means even more that you’ll pay in interest.

The term of your loan is the length or amount of time it will take to pay off the loan. For installment loans, like car loans and mortgages, the term is agreed upon at the start of the loan. For example, mortgages generally have terms of 10, 15 or 30 years. Car loans typically have terms of 4 to 7 years. Payday loans typically have terms of a few weeks or a month.

When a bank loans you money, they are taking on the risk of you not paying them back. Sometimes, a loan will require something of great value that you agree you would give up if you cannot pay back your loan. This item of great value is called “collateral.” Some loans naturally have collateral. With a mortgage, the house is the collateral. For car loans, the car is collateral. With smaller, personal loans, it is sometimes the case that you need to choose an item of value (e.g. car, jewelry, etc.) to place as collateral. Loans with collateral agreements tend to require less in interest payments due to the decrease in risk of not getting paid back.

Most loans are not free. Imagine you are a bank, and someone asks for $1,000 with a promise to pay it back. Why would you give them that loan? If they only paid back $1,000 and nothing else, that is simply bad business for your bank. Instead of loaning that $1,000, you could have used it to invest it. Further, there is a risk that the person won’t pay back that $1,000. So, as compensation for both losing the opportunity to invest that $1,000 and taking on the risk of not getting the money back, you want to charge the borrow extra money. This extra money is interest.

Interest is what makes loans possible. By giving out a loan with interest, the loan is a kind of investment. By taking on the risk of lending money, the bank expects investment compensation via interest.

Interest is one of the most important, and most complex, terms of a loan. How large interest payments are and how they’re calculated can heavily impact how much someone can borrow and how well they’ll be able to pay off the loan. We discuss this next.

Some loans cost money to actually process and start. For example, taking out a loan for a mortgage requires work to transfer the deed to you. It requires a title office and a lawyer, among other things. These fees are generally paid by the person taking out the loan. This can happen in two ways. In one way, the loanee pays all the fees up front when the loan begins. However, since most people don’t have the needed money to pay fees up front, fee costs are paid in small increments as the loanee pays back the loan.

For the vast majority of loans, interest is calculated based on the APR or annual percentage rate. For simplicity, let’s assume that loan payments are made once a year. Suppose you have a loan balance of $10,000. If your APR is 6%, then the amount of interest you need to pay at the end of the year is \(10,000 \times 0.06 = \$600\text{.}\) Now, if your APR was 15% instead, then the amount of interest you need to pay at the end of the year is \(10,000\times 0.15 = \$1,500\text{.}\) As you can see, when you take out a loan, you generally want the lowest APR possible.

What your APR will be is determine by a few factors. The type of loan (mortgage, car, payday, etc.) is a big factor. Below are some ranges of current APR’s for types of loans:

You’ll notice vastly different rates for different types of loans. As we’ll explore later, there are reasons behind these differences.

Your credit is also a major determinant of your APR. Because interest payments are compensation for the risk of lending you money and your credit is a measurement of how likely you are to pay back money, it makes sense that those with higher credit would need to pay less in interest (lower APR). Those with lower credit would need higher APR’s.

Other factors of APR’s include the length or term of your loan and whether there is any collateral.

There is one little fib I made about APR. Technically, APR doesn’t count just interest. It also includes fees on the loan. You may see loans rates advertised with two percentages: the “rate” and the APR. The loan rate is what is used to calculate just interest. The APR is used to calculate interest and fees combined. Effectively, the APR can be used to calculate your actual loan payments.