Interest:  Just another fancy word for fee

Interest: Just another fancy word for fee

I like to keep things as simple as possible, and in my quest for simplicity I’ve had to learn how to cut through the crap. As Iyanla Vanzant loves to say, “call a thing, a thing.”

This is especially true with fees charged by people and companies.  A fee is what someone charges for their services. However, there are plenty of names used in place of the word fee. The name generally tells you what the fee is associated with. For example, a premium is the fee for insurance, commission is the fee for sales, toll is the fee for crossing a bridge, load is the fee for buying and selling stocks, a donation is the fee associated with a charity event, etcflickrInterestRateStreetSign.

Interest is the fee a lender charges for loaning money. It’s normally shown as an annual percentage rate (APR), and often in a set range (i.e. interest rate of 2.25%-10.75% APR). Where you fall within the range depends on a few factors, but largely on your credit score (see Your Credit Report Is Your Reputation Report).

Knowing that interest is a fee, I always want to know how much is the fee and its effect on my payment, and I’m talking dollars not just percentages. That’s what’s coming out of my pocket. I won’t bore you with some long complicated formula, I’ll just give you three things that have a major effect on any loan’s fees. They are the interest rate, the loan amount and the loan term (how long it takes you to pay the loan off).

To see these three factors in action, let’s say *Kim, *Nicole and *Jennifer want to buy a new car. The three ladies are strangers, however, they all go to *ABC Bank on the same day and talk to the same loan officer (3 different appointments) regarding a vehicle loan. On this particular day vehicle loan rates are 2.25% – 10.75%. For simplicity sake, let’s say they all make the same salary; however, Kim’s credit score is 550, Nicole’s credit score is 675 and Jennifer’s credit score is 800. Take a look at the following purchasing scenarios:

Purchasing scenario #1: Same loan amount and term, different interest rates

Kim Nicole Jennifer
Int. Rate 10.75 5.00 2.25
Loan Amt. $25,000 $25,000 $25,000
Loan Term 60 mos. (5 yrs.) 60 mos. (5 yrs.) 60 mos. (5 yrs.)
Monthly Pymnt. $540.45 $471.78 $440.93
 
Total Fees $7,426.93 $3,306.85 $1,456.02
Total Amt. Paid $32,426.93 $28,306.85 $26,456.02

Remember, I said where you fall within the interest rate range can depend on your credit score. All things being equal, the higher your credit score, the better (meaning lower) the interest rate. This means lower fees and lower monthly payments. While all three ladies qualified for the same loan amount over the same term, based on the table above, Kim will pay $7,426.93 in fees versus Nicole’s $3,306.85 and Jennifer’s $1,456.02. These fees are why Kim’s monthly payment is about $100 more than Jennifer’s.

Purchasing scenario #2: Same loan amount and interest rates from scenario 1, different loan terms

Kim Nicole Jennifer
Int. Rate 10.75 5.00 2.25
Loan Amt. $25,000 $25,000 $25,000
Loan Term 84 mos. (7 yrs.) 60 mos. (5 yrs.) 36 mos. (3 yrs.)
Monthly Pymnt. $424.78 $471.78 $718.80
 
Total Fees $10,681.67 $3,306.85 $876.66
Total Amt. Paid $35,681.67 $28,306.85 $25,876.66

Operating off the credit scores stated above, the interest rates will not change from scenario 1, let’s look at the effects of changing the loan terms. How much time it takes you to pay off a loan can drastically effect your monthly loan payment and the amount of fees you pay. Here’s how it works:

  • The longer the term, the lower the monthly payment and the more fees you’ll pay (at your approved interest rate)
  • The shorter the term, the higher the monthly payment and the less fees you’ll pay (at your approved interest rate)

Comparing scenario 1 to scenario 2, Kim wanted to see the effects of extending the loan out two more years (7 years) in an effort to reduce her monthly payment. This reduces her monthly payment by $115.67, but as a result she will be paying ABC Bank $3,254.74 more to borrow the money. Jennifer wants to see the effects of shortening her loan by 2 years (3 years). This will increase her monthly payment by $277.87 and decrease her fees by $579.36.

Purchasing scenario #3: Same term and interest rates from scenario 1, different loan amounts

Kim Nicole Jennifer
Int. Rate 10.75 5.00 2.25
Loan Amt. $20,000 $15,000 $30,000
Loan Term 60 mos. (5 yrs.) 60 mos. (5 yrs.) 60 mos. (5 yrs.)
Monthly Pymnt. $432.36 $283.07 $529.12
 
Total Fees $5,941.54 $1,984.11 $1,747.22
Total Amt. Paid $25,941.54 $16,984.11 $31,747.22

Again, the interest rate will remain the same as scenario 1, but this time let’s change the loan amount. It is clear that, of the 3 women, the one who borrows the least amount has the lowest monthly payment, which is Kim.  If you compare scenario 1 to scenario 3, the fees go up or down based upon the individual’s loan amount going up or down.

Here’s something interesting, look at the “Total Fees” row in scenario 3. Despite the fact that Jennifer is borrowing the most and has the highest monthly payment, over the course of 5 years, she’s still paying the least amount of fees. Why? Because she has a much lower interest rate. Also, Jennifer’s monthly payment in scenario 3 (where she borrows $30,000 over 5 years) is still lower that Kim’s monthly payment in scenario 1 (where she borrows $25,000 over 5 years).  Jennifer can add a few extras to her new car (a sunroof, heated seats  or a better stereo system maybe).

No matter the scenario, it’s you can see that interest rates play the biggest factor when it comes to fees. Again, lenders use your credit score to determine what rate they will offer you. Regardless of whether your score is 550 or 800, you can afford a $300 or an $800 monthly payment, you plan to borrow for 3 years or 10 years, knowing your credit score before speaking to a lender is one of the best steps you can take.

Interest is one of the ways a bank (or any lender) earns money. Knowing your credit score and how it relates to interest will put you in the position to negotiate, walk away from a bad deal or understand the need to improve your financial position before moving forward with a purchase.

 

Note:  Figures were calculated using the “How Much Will Your Loan Really Cost” calculator at PracticalMoneySkills.com.

*fictitious characters and institution


Photos by GotCredit.com and 401kCalculator.org via Flickr under Creative Commons.

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