Learn / Part 3 · Inside the Financial System
The True Cost of Borrowing
What does borrowing really cost?
In brief
The price of a loan is not the monthly payment. It is the total repaid minus the amount borrowed, plus fees, and it depends on whether the rate is flat or on a reducing balance.
Key ideas
Payment is not price
Stretching a loan lowers the payment and raises the total cost.
Make an insight card →Flat rates mislead
A flat rate charges interest on the original amount throughout, so it costs about double an equal reducing-balance rate.
Make an insight card →Fees change the rate
Charges paid up front mean you receive less than you owe, raising the effective rate.
Make an insight card →Try it
True cost of a loan
The monthly payment is what lenders show you. The cost of credit is what you pay. Enter the offer exactly as quoted, including any flat rate or fees.
Open the full page: formula, variables, worked example and cautions →
Also relevant: Compare two loan offers, Rate translator
Red flag
A loan advertised only by its monthly payment.
Ask before you sign
- What is the total I will repay, and what is the effective annual rate?
- Is the rate flat or on the reducing balance, and what fees apply?
Do this week
Ask a lender to give the offer in writing, including the total repayable.
Try it · 10–45 minutes
Take a loan or card statement and calculate its total cost of credit.
Connected ideas
Where else this shows up
Pause and reflect
Private to this device. Nothing is sent anywhere.
Words worth knowing
- APR (annual percentage rate)
- A yearly cost-of-borrowing figure. Definitions vary by country; in some places it includes fees, in others only interest. Always ask what it includes.
- Flat rate
- A way of quoting interest on the original loan amount for the whole term, even as the balance falls. It costs far more than the same figure on a reducing balance.
- Reducing balance
- Interest charged only on what you still owe. The fair basis for comparing loans.
- Amortisation
- Repaying a loan in regular instalments so that the balance reaches zero at the end of the term. Early instalments are mostly interest; later ones are mostly principal.
- Effective annual rate (EAR)
- The rate that a year of borrowing or saving really adds up to once compounding is included.
- Principal
- The amount borrowed, as opposed to the interest charged on it.
Companion notes written for this website, based on the topics of Chapter 11. They explain ideas and do not reproduce the book. General information, not personal advice.