Req 7a — Loans & Interest

What Is a Loan?

A loan is borrowed money that you agree to pay back over time, usually with interest. When you take out a loan, the lender (a bank, credit union, or other institution) gives you a lump sum of money. You then make regular payments — usually monthly — until the full amount plus interest is repaid.

Loans are a part of everyday life. Most people use loans to buy homes, cars, and pay for college because these things cost more than they can pay at once. The key is understanding how loans work so you borrow wisely.

Every loan has these components:

• Principal: The original amount you borrow
• Interest: The cost of borrowing — the extra money you pay the lender for the privilege of using their money
• Term: How long you have to pay it back
• Monthly payment: The amount you pay each month (includes both principal and interest)

What Is Interest?

In Requirement 4, you learned about interest as something you earn on savings. With loans, interest is something you pay. It is the price of using someone else’s money.

Think of it like renting. When you rent a bike for a day, you pay a fee for using it. When you borrow money, interest is the “rental fee” for using someone else’s cash.

Understanding APR

The annual percentage rate (APR) is the most important number to look at when comparing loans. It tells you the true cost of borrowing money, expressed as a yearly percentage.

Why not just look at the interest rate? Because some loans have hidden fees — origination fees, processing charges, closing costs — that make the actual cost higher than the interest rate alone. The APR rolls all of these costs together into one number, making it easier to compare different loan offers.

Example:

• Loan A: 5% interest rate, $500 in fees, APR = 5.8%
• Loan B: 5.5% interest rate, no fees, APR = 5.5%

Loan B looks more expensive at first glance (5.5% vs. 5%), but when you factor in fees, Loan A actually costs more. The APR reveals the true picture.

How Loan Interest Adds Up

The total cost of a loan depends on three factors: the amount borrowed, the interest rate, and the length of the loan. Here is a real-world example:

A $10,000 car loan at 6% APR:

• 3-year term: Monthly payment of $304, total interest paid = $950
• 5-year term: Monthly payment of $193, total interest paid = $1,600
• 7-year term: Monthly payment of $146, total interest paid = $2,260

Notice the trade-off: a longer term means lower monthly payments but much more interest paid overall. The 7-year loan costs you $1,310 more in interest than the 3-year loan — that is money you are paying just for the convenience of smaller monthly payments.