When making expensive, but necessary purchases throughout your life, such as financing a car or mortgaging your home, the majority of us can’t pay the full amount up front. For instance, a home in this day and age can cost well over $350,000. That’s why lenders, banks, and other financial institutions provide people with loans. Today, you can get a loan for just about anything. You can acquire a car loan, student loan, personal loan, small business loans, and many more.
Although loans are very useful and help you obtain these essential purchases, they can hurt your credit if not managed properly. While paying off your loan balance, you will also be required to pay “interest” with every payment increment. These interest rates, coupled with your regular loan payments, can certainly take a heavy toll on your finances, especially when those rates are high. That’s why, when you’re in the market for any type of loan or credit product, it’s best for you to consider all factors and shop around for an interest rate that’s best suited to your financial status.
What happens when you can’t afford your loan payments? Click here to find out.
What is an Interest Rate?
Essentially, the interest rate is how your lenders make a profit from you for the use of their services, meaning the money you’re borrowing. For instance, when you’re investing in a car or home, some money can be put down up front, while the rest is paid in predetermined installments over a certain period of time. These payments will include a prearranged amount plus added interest due to the borrowed money.
For a more detailed article about interest rates, click here.
The Benefits of a Low-Interest Rate
Your interest rate is one of the most significant factors when determining how much extra you’ll be paying to borrow money from your lender. The lower your interest rate is, the less money you’ll end up paying over time. Receiving a low-interest rate should be your top priority, so spend time shopping around for the lowest amount, no matter what kind of credit product you’ll be applying for.
If you have a high credit score and a positive credit report indicating a history of consistent payments for your other products, such as credit cards, you should be eligible for a lower percentage when you apply for any new loan. However, if you have a negative history including late, short, or missed payments, you likely have a low credit score and thus receive a higher interest rate.
While it may seem obvious that obtaining a low-interest rate is better, it’s not always easy to get. That’s why shopping for interest rates should be a timely process, in order for you to get the lowest interest rate possible. If you receive a low-interest rate and manage to pay off your full loan amount in a short period of time, thousands of dollars can be saved on your end.
Contrarily, if you’re stuck with a high-interest rate and pay off the loan over a long period of time, you’ll lose a substantial amount of money because you’re paying extra interest for each month borrowed. Simply put, it’s best to pay off your loan as quickly as possible to avoid extra interest charges. This is why it’s important to review all possible options and see where you can get the lowest interest rate, with the best repayment terms.
Increasing Your Credit Score
Knowing this, you should immediately take steps toward raising your credit score so you can be eligible for the lowest interest rate in the future. You can start by paying all your existing credit product bills on time and in full. With every timely bill payment you make, your score will rise a few points.
If you don’t have a credit history at all, but still want a loan, try applying for a simple credit card or line of credit. Not having any credit may be why your score is low, so be sure to start as soon as possible.
Read this to find out how the length of your credit history affects your credit score.
Increasing your credit score is the first step toward attaining a lower interest rate. The majority of lenders demand a minimum credit score of 620 to 640 for things like mortgage approval, but anywhere above 740 puts you in the ultimate position. Like we said, the higher you manage to get your score, the less of a financial risk your lenders will consider you, and the more likely you’ll be to get a low-interest rate.
Making a Larger Down Payment
When searching for a favorable interest rate, It’s good to know that making larger down payments for more expensive credit products, such as car loans and mortgages, may also help get you a lower interest rate. When you’re able to put down enough money to own a larger portion of the property in question, it’s another sign to your lenders that you’re less of borrowing risk. After all, no matter how much you’re borrowing, the first thing that your lenders want to know is that you’ll be able to pay them back in full.
Click here to learn how you can get a down payment on a house in Canada.
As a basic example, let’s say you’re applying for a mortgage. When you make a down payment of 20% or more of the total amount, it’s what’s known as a “conventional” mortgage, while a down payment of less than 20% is considered “high-ratio”. While high-ratio mortgages are more common and ultimately affordable for homebuyers these days, your interest rate would likely be higher than it would be if you were to invest in a conventional mortgage. Once again, the larger your down payment is, the lower your interest rate will, simply because your lenders feel that you’re more stable financially.
So, if you can afford such a down payment of 20% or more, and you’re still able to keep up with your regular mortgage payments, you may benefit from it greatly in the future, in more ways than one. Not only will your interest rate be lower, but your “amortization”, or payment period, will be shorter, meaning you’ll likely own the house and be out of debt sooner.
If you’re not certain you’ll be able to afford your future mortgage payments, try performing your own “stress test”.
Shorter Repayment Periods
Generally speaking, the longer your amortization period is, the more your bank or another lender will profit, no matter what type of loan product it pertains to. Remember, every time a payment comes around, it includes an interest. Therefore, paying your loan off over a longer period means you’ll be paying extra money in interest the entire time. This is why it’s highly recommended that you pay off your loan, in full, as soon as you possibly can.
To learn the difference between a mortgage term and a mortgage amortization? Click here.
As another example, short-term loans typically come with lower interest rates and higher payments. Yes, your payments will be more expensive, but you will still save a ton on interest in the long run because you’ll pay it off faster. Paying off your debt quickly will also give you some peace of mind, knowing your liabilities are taken care of.
Fixed-Rate (Closed) Vs. Variable-Rate (Open) Mortgages
When you’re shopping for a mortgage, there will be two types of interest rates that you can choose from, both of which come with certain pros and cons.
Fixed-Rate/Closed
If you’re investing in a home, having a “fixed-rate” or “closed” mortgage can be a much safer plan for many borrowers. Basically, your interest rate is fixed or locked in over the course of your amortization period. With this fixed mortgage, you not only receive a lower interest rate, but you can also enjoy a steady and consistent payment schedule.
With a fixed amount being paid toward the mortgage every payment period, you can control your cash flow, knowing how much you’ll be paying in advance. This provides many benefits, one of which is that you’ll be able to create a realistic budget, as you’ll be aware in advance of exactly how much each payment will cost. In addition, you can sleep peacefully knowing your interest rate won’t change overnight.
One downside to a fixed-rate mortgage is that you’ll be required to pay a penalty if you make contributions to your regular payments that are above the predetermined amount. This can also occur if you pay off the full mortgage before the agreed-upon maturity date.
Variable-Rate/Open
With a “variable-rate” or “open” mortgage, your payments will rise and fall in accordance with the current market interest rate, also known as “prime rate”, which fluctuates on regular basis. This means if interest rates skyrocket overnight, you can be stuck paying a very high amount until they go down. While having a variable interest rate does come with certain benefits it’s important to realize the downsides of choosing it over a fixed rate before you make your choice.
Not being able to lock in a certain interest rate can be very risky and stressful. In the past 25 years, interest rates have been declining and slowly stabilizing over time. In recent years, however, interest rates have gradually been going up, which is why it can sometimes be more beneficial for you to secure a guaranteed, permanent rate.
On the other hand, a variable-rate mortgage allows you to make advanced payments without being penalized for it. So, while a fixed-rate mortgage means you’ll be charged a penalty fee for paying ahead of time, having a variable rate gives you the opportunity to pay off your mortgage faster. In turn, if the prime rate goes down, your own interest rate will too, meaning you could once again stand to pay less over time.
Given that both options provide advantages and disadvantages, it’s best to discuss the issue with both your lender and a professional mortgage specialist before you make your final decision.
For more information about fixed and variable rate loans, read this.
Secured or Unsecured Credit?
Depending on the nature of the loan in question, another factor exists pertaining to how your interest rates will be calculated.
Secured Loans
“Secured” loans, such as car loans or mortgages, are loans that are backed by an asset or some other form of collateral.
“Collateral” is essentially a way for your lenders to feel more safe about the loan money they’re lending you in the first place. So, for example, if you default on your car payments, your lender might seize your car to cover their loss. In fact, lenders and other financial institutions can hold these kinds of assets until you’ve paid your loan in full. If you’re unable to pay, they can sell the property as a way to pay off at least part of what you owe them. Other types of secured loans include stocks and bonds, and any loan that’s weighed against any personal property that’s of significant value, such as your home or another piece of real estate.
To learn more about what happens when you default on loan payments, read this.
One clear advantage to secured loans is that, since you’re offering up assets as collateral, you’ll often be given a lower interest rate, accompanied by more reasonable repayment terms and a higher borrowing capacity.
Unsecured Loans
An “unsecured” loan, on the other hand, does not require collateral. This type of loan is usually given to individuals who can afford to repay the loan based on their current and future finances. These types of loans include products like student loans or purchases on your credit card. Lenders are taking a bigger risk here because there is no collateral; meaning if you default on payments, there is nothing they can take away to make you pay. This is why interest rates on unsecured loans are higher.
Click here for a more detailed article about secured and unsecured debt.
The Make and Model of Your Car
If you’re investing in a car, the make and model plays an important factor with regards to the interest rate.
When shopping for a brand new car, many lenders will offer you a lower interest rate and a longer payment period. That’s because when a borrower defaults on their payments, lenders will automatically reclaim the car and will generally have less of a hard time reselling it elsewhere. Because the car is probably in better condition than one that’s been driven more, they may be able to recover a larger portion of their investment.
On the other hand, if you were trying to finance a used vehicle, but you started defaulting, lenders would have a much harder time reselling the car after repossessing it. This is why older makes and models of cars often come with higher interest rates when you purchase them.
Other Important Steps to Consider
At Loans Canada, we understand how tough it can be to find the right interest rates, ones that will adhere well to your financial needs. Since a high-interest rate could mean you’ll end up paying hundreds, maybe thousands of dollars more than you’re comfortable with for your loans and credit products, it’s best that you consider all factors before you make your decision.
Always Shop Around First
It’s vital to obtain information from multiple lenders in order to compare interest rate options and choose the best one. If possible, get a referral from a trusted friend or family member, then contact his or her lender if need be.
Trying to compare lenders in Canada? Look at this article first.
If not, contact a mix of financial institutions and gather information on each. Remember that you’re the one making the final decision, so you should always choose the lender that offers the best interest rate for your finances.
Do Extensive Research and Be Prepared
Obtain all cost information for your credit products. It’s best to do a lot of research and ask about all extra fees involved with securing a loan of any kind. Knowing the loan amount and interest rate isn’t always sufficient. Always make sure to ask all the questions you need to. For example, how will your down payment affect your payment plan and interest rate? What will the length of the payment term be? What about any additional fees, such as brokerage or settlement fees, underwriting fees, closing costs, mortgage insurance? The list can be extensive and every element will affect your finances in a different way.
Check out our useful infographic: The Cost of Buying a House in Canada.
These extra charges are often dependent on the lender or financial institution you’re dealing with. In fact, any good, legitimate lender should be able to give you an estimate of these fees in advance. While some fees can be paid when you apply for the loan, others can be paid at maturity. On top of that, showing the lender you’re prepared and ready to pay is a good indication to them that you’re a serious borrower, which could ultimately get you a lower interest rate.
In the end, when you’re trying to compare your options and shopping for the right interest rate, it’s imperative to consider all the potential costs involved when you apply for any type of loan. As time goes by, you don’t want to be surprised by any additional fees or costs. The goal here is to save money!
Check out one of our other infographics: The True Cost of Borrowing.
Take Your Time! Get Advice!
In conclusion, taking your time and obtaining the right loan, one that’s relative to your personal finances, can save you a large amount of money in the long run. Depending on what you can afford now and in the future, your loan and its requirements must be economically plausible. Don’t assume you’ll be making more money in the future and agree to terms you simply can’t afford, just for the sake of getting the loan.
Despite how rushed you may be to receive the loan, making a quick and impulsive decision can be detrimental towards your finances in the long run. Remember, once you get the loan, you’re stuck having to pay it off. Depending on your lender and your agreements, you may not even be able to change certain requirements.
Therefore, it’s best, when shopping around for a loan, that you fight for a low-interest rate. For the benefit of your finances, a good tactic is to start saving now in order to make a bigger down payment, and most importantly, weigh your options. If you’ve been searching around and are still confused about anything involving loans or the interest rates that come with them, seek the help of a financial advisor. As long as you’re determined and you act responsibly, you’ll find a way to get the best deal possible.
