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The true cost of credit

Alison Fearon from Switcheroo.ie explains the total cost of availing of credit facilities.

In today’s world, credit facilities come in many shapes and sizes, and most people will eventually find themselves in a position when they have to avail of one. The reason why can range from needing a Credit Card to rent a car while on holiday, needing a loan to purchase a car on short notice when you don’t have the savings yourself, or needing a mortgage to purchase your dream home. The truth is the majority of us will go through life needing to avail of credit facilities on more than one occasion, and that’s why it is important to understand how much credit will cost you before agreeing to any of these financial products.

Understanding the total cost of credit and the drivers of this cost can be a little complicated. There are three main drivers of the cost of credit:

· the amount you borrow

· the interest rate you borrow at

· how long you take to pay it back

The amount you borrow you will always have to pay back. If you borrow €1,000 you will always have to repay this amount but where the cost of credit varies is in the interest rate and the length of time you take to pay back the loan.

People often focus too much on what the monthly payments are, while they are clearly part of the equation, small differences can be misleading over long periods. This is most dramatic with mortgages where long duration of contracts can lead to big swings in cost of credit.

As an example, let’s take a mortgage of €200,000 over a term of 35 years on an interest rate of 2.5%, the monthly repayment will be €715 per month, and the total interest payable over the 35 years will be €100,296. Many people mistakenly think in the minds that they are paying back €200,000, they are not, the total payback is €300,296, with the total cost of credit representing >50% of the initial loan taken.

However, if we were to reduce the term to 20 years on the same interest rate of 2.5%, the monthly repayment will be higher at €1,059.81 per month, but the interest payable will be considerably less at €54,353.39. That’s a difference of almost €46,000 that can be saved by paying the mortgage back over the shortest term. How long you take to pay back a loan has a big difference on the overall cost of the loan. Even in with super low interest rate environment we are in now, but it will have an even greater impact if rates rise.

When it comes to all credit facilities, it’s important to avoid the temptation of paying the lowest amount back as possible as this will cost you the most in the long term. Extending the term of a loan makes life easy in the short terms but much more costly over the long term. Sit down and budget what you think the most you can comfortably afford is and base the repayment of your credit facilities on this as it can save you huge amounts. Credit facilities are undoubtedly useful at times, but it’s important to manage them correctly to avoid spending needlessly on interest.