Understanding the cost of borrowing money

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KEY TAKEAWAYS

✔  “Cost of borrowing” refers to the total amount of money you will repay to a lender.

✔  All Canadian lenders must tell you the cost of borrowing before you get a loan. It’s one of the ways the system keeps things fair and honest.

✔  The cost of borrowing will vary based on the type of loan, the interest rate, and whether or not fees apply.

Canadian rules are very clear when it comes to lending money. All lenders must tell you how much it will cost to pay off the amount you borrow (the principal) plus the interest and any fees over time. This is called “the cost of borrowing”. It’s helpful to anyone looking to borrow money because it ensures you understand how much you will pay, in total, for the loan. 

3 factors make up the cost of borrowing:

The loan amount (the principal) is the amount of money you want to borrow.

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%  The annual percentage rate (APR) is the percentage amount a lender charges you to borrow money over the term of the loan. 

The term is the set length of time you choose to pay off the loan.

Together, these three factors make up the amount of your payments (either weekly, biweekly or monthly). 

Understanding the cost of borrowing lets you compare lending options so that you can make an informed decision when it’s time to borrow for whatever you need. 

3 factors affect the cost of borrowing

1. The type of loan 

Loans fall into two basic categories: Secured and unsecured. A loan is considered “secured” when you offer the lender some kind of collateral (something that can be sold to pay off the loan if you can’t). For example, a car becomes collateral on a car loan. A home is used to secure a mortgage. 

If you own assets in another country and you want to use them as collateral for a loan in Canada, you’ll need to ask your bank about its policies. 

An unsecured personal loan typically has a higher interest rate so if you have collateral, talk to your lender about using it to get a lower interest rate.

2. Interest rate

Interest is the amount of money you pay in addition to the principal amount you borrow. Getting the best interest rate based on your credit history and financial situation is the key to lowering your total cost of borrowing. Interest rates are usually followed by the letters APR, which stands for annual percentage rate. 

Here are a few ways to qualify for a lower interest rate on your next loan. 

Collateral – use an asset to “secure” the loan. 

Credit rating – take steps to build and keep a good credit score.

Loan insurance – purchasing loan insurance may result in lower interest and savings on the total cost of borrowing. 

3. Amortization (the term)

Amortization simply means the total length of a loan. You and your lender get to agree on the number of months, or years, that you will take to pay off the debt. This decision affects the amount of interest you’ll pay and the cost of each payment. For example, you can take out an unsecured loan from easyfinancial and pay it off fast over a few months, or take up to seven years. Changing the amortization period of a loan has two immediate effects:

A longer amortization results in lower monthly payments but a higher cost of borrowing over time. 

A shorter amortization results in higher monthly payments but a lower cost of borrowing. 

Here’s how the cost of borrowing compares for the same loan amount (the principal) of $5000 at the same interest rate of 9.99% over three amortization periods – 12, 24 and 36 months.