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Why Focusing on Monthly Payments Is the Wrong Approach to Your Personal Loan

Christy Bieber, The Motley Fool

 

Just because a monthly payment wouldn't break the bank doesn't mean a personal loan is a good idea.

Man with money flying out of his wallet.

Image source: Getty Images. 

When applying for a personal loan, many people focus on one thing and one thing only: whether they can afford the monthly payment. And, indeed, many lenders encourage this type of thinking by touting how affordable the loan payments are each month.

While you need to make sure you can pay the loan bill when it comes due, monthly payment is just one factor affecting the total cost of your loan -- and it’s not necessarily the most important factor. Focusing on monthly payments at the expense of looking at the big picture can be a big mistake, and it’s important to understand why.

Here are a few key reasons why you need to look beyond whether your loan payment would fit within your monthly budget.

Lenders make monthly payments look more affordable by stretching out the loan term

Lenders want you to view loans as affordable, and they know many people focus only on the monthly payments that they’ll have to make. Lenders capitalize on this short-term thinking by advertising loans with “payments as low as $X per month.”

The problem is, when you see this “low monthly payment” and it seems like it will fit well into your budget, you may forget to look at just how long the lender expects you to take to pay back your loan. Lenders know this, so they often quote those very low monthly payments by offering you a loan with a very long repayment timeline.

Unfortunately, with a loan that has a long repayment timeline, you pay interest over a very long period of time. Even loans with relatively low interest rates can become expensive when you continue to send monthly interest payments to the lender over a longer amount of time.

A focus on monthly payments obscures the total cost of your loan

With any loan you take out, the number you should focus on isn’t the monthly payment, but the total cost of borrowing. You want to keep this total cost of borrowing as low as possible so you don’t waste a fortune making your lender richer and yourself poorer.

If you focus on monthly payments alone, a loan may not seem that expensive. After all, $50 or $100 a month may seem like pocket change. But if you pay a low monthly payment for a long enough period of time, the costs can really add up.

Say, for example, you take out a $7,000 loan at 10% interest compounded monthly. If you repay the loan over three years, your monthly payment would be $225.87 and the total amount of interest you’d pay would be $1,131.33. While paying over $1,100 in interest is a lot, it’s not ridiculous.

What if you stretched out your repayment timeline to 10 years? Your monthly payment goes down to $92.51 -- which, at first glance, may sound much better and much more affordable than $225.87. But the total interest you’d end up paying over that period of time would be $4,100.66. You’re paying almost four times the interest for this longer loan. Paying more than $4,100 in interest to borrow $7,000 is a lot!

Striving for a lower monthly payment could mean you’re in debt for much longer

A low monthly payment that comes from a longer debt repayment process could also leave you indebted for a much longer period of time. Delaying your debt-free date means it will take longer until you can divert the money you’re making in monthly debt payments to other goals, such as saving for retirement or saving for a house.

The outstanding debt balance and monthly payments will also affect your debt-to-income ratio for longer. Your debt-to-income ratio is used by lenders to determine how risky it is to lend to you. A higher debt-to-income ratio means you may be denied for some loans, such as mortgage loans, or may have to pay a higher interest rate.

When possible, it’s best to pay back your personal loan as quickly as you can so you can reduce this debt-to-income ratio and become debt-free faster. 

Personal loans aren’t considered “good debt” like student loans and mortgage debt. The interest rate on personal loans is often higher than the rate you could earn if you invested your money instead of paying the loan back. And there’s no tax deduction available for personal loan interest.

There’s no reason to keep these loans around for any longer than necessary -- so aiming to become free of the debt ASAP is a better idea than settling for a loan with lower monthly payments.

Looking at monthly payments may mean missing the fine print

Finally, focusing on the monthly payments could obscure other important loan terms that make your loan cost more or that make repayment harder.

For example, if a loan charges a higher origination fee to give you a slightly lower monthly payment, it may not be worth it depending what the fee is and whether your payment savings make up for it.

You may also want to avoid loans with prepayment penalties -- even if they have lower monthly payments -- because you could be trapped in the loan even when you have the money to pay it back early since the fee could negate any savings in interest early repayment would provide.

You’ll want to look, in detail, at all of the loan terms. Make sure the lender is honest, that there are no hidden fees, and that the loan is affordable when taking all costs into account. Don’t let a low monthly payment obscure these other important details.

Focus on the big picture instead of on monthly payments

Instead of looking at monthly payments when deciding whether to take out a personal loan, look at the total loan cost. Consider the total amount of interest you’ll pay, how many years you’ll be paying the debt, and what fees you’ll pay for the loan.

By looking at all of the loan details, you can make sure that the loan actually comes at a reasonable cost and you can compare loan offers more effectively to find the lender that’s offering the best deal overall. You’ll be far better off getting a loan that costs you much less, even if the monthly payment may be just a little bit higher.

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