Thursday, 2 May 2013

The Cheapest Loan

You’ve done your homework on understanding how debt works and decided to take on a loan.  No matter whether that loan is a mortgage, personal loan or credit card then the next step is to ensure that you end up with the cheapest or lowest cost loan you can, along with one that actually meets your needs.  To do this you have no choice but to find a quiet place, where with a fresh cup of tea, you can read the small print of each loan provider you are considering and in parallel run some maths to calculate who is the cheapest provider based on all that small print.  It’s key to do the maths because when it comes to loans, as with investments, small amounts over long periods and fees matter.

If you want to do the maths yourself then Excel’s PMT function will get you a long way.  This gives the repayment amount for a loan given an interest rate, the number of constant periods the loan is taken over and the present value of the loan.  If you don’t have Excel or aren't mathematically savvy then you could also use a loan or mortgage calculator to do a lot of the work for you.

Let’s look at a few simple case studies, which build in complexity, to show just how important it is to run the numbers.

Case Study 1 - All else being equal secure the lowest interest rate you can  

Bank A is offering a loan with an annual interest rate of 5% (the interest rate) and Bank B has a rate of 5.5%.  The loan amount is for £10,000 (the present value of the loan), you are going to make the repayments monthly and you intend to take the loan over 10 years (the number of constant periods will be 10x12=120 months because you pay monthly).   To calculate the monthly repayment for the first scenario you would enter the following into Excel ‘=PMT(5%/12, 10*12,-£10,000)’ which would give you a repayment to Bank A of£106.07 per month.  Note you have to divide the interest rate by 12 months as the repayment is made monthly.  If you run the same calculation for Bank B’s interest rate of 5.5% the monthly repayment would be £108.53.

At first glance it doesn’t seem like much of a difference.  After all it’s only £2.46 per month however this is no different to the Latte a Day case study I’ve run before which demonstrates how small amounts matter.  Over the 10 year period the total interest paid is £2,728 and £3,023 respectively.  That 0.5% actually means 10.8% more in interest payments.   It’s also important to remember that the longer the loan period the worse this effect.  For example lengthen the loan term to 20 years and that 10.8% becomes 11.5%.  This is Compound Interest at work.

Case Study 2 – Pay the loan off in the shortest time possible  

You settle on Bank A however on reading the small print you discover they won’t allow you to pay the loan off any quicker than the agreed 10 year period without hitting you with very high early repayment charges.  Bank C however has an identical offer to Bank A except they allow over payments.   Under this scenario Bank A’s monthly repayments haven’t changed at £106.07.  If however you took out the loan from Bank C and found you were actually able to pay £115.17 per month then that loan term reduces to 9 years.  Under these scenarios the total interest paid over the loan term from Bank A is again £2,728 and from Bank C it’s £2,439.  So by making 8.6% more in repayments per month you’ve saved yourself 11.9% in total interest payments.

Of course, you could choose to take the Bank A loan over a 9 year period and both would come out equal.  Personally though under this type of scenario I’d always use Bank C because it means you aren’t forced to stretch yourself so far thereby reducing your risk should your ability to repay be hindered for any reason.  After all you can always continue to make the lower repayment and take the 10 years with Bank C where with Bank A you cannot if you lock into 9 years.

Case Study 3 – Watch for other charges that can make that attractive looking loan more expensive  

Here you are looking for regular or irregular costs that are not constant interest charges.  This might include establishment or arrangement fees, monthly fees on top of the interest charge, early repayment penalties or interest rates that change part way through the loan period.

This time you’re taking out a £100,000 mortgage for a house.  It’s a 20 year mortgage and you make the repayments monthly.  You are comparing two mortgages which are initially 2 year fixed deals but which then revert to the providers uncompetitive Standard Variable Rate after those 2 years.  You therefore know that at the end of the 2 year period you are going to be remortgaging with whoever gives you the best deal at that time.

Bank X has an annual interest rate of 3.5% but has an arrangement fee of £999 where Bank Y has a rate of 4% and no arrangement fee.  If we were just to look at the interest rates then Bank X would look to be the better deal however by using the PMT function again plus adding the fee onto the calculated repayments it actually transpires that over the 2 year period you would have paid £14,918 in repayments and fees with Bank X and £14,543 with Bank Y.  Therefore Bank Y is actually the better deal over that 2 year period even though Bank X has the lower interest rate.

Taking out a loan is a very serious affair.  These case studies, while covering nowhere near all eventualities as loans can be and are complicated, demonstrate just how important it is to take the time to do your own research.  This includes reading all of the T&C’s and importantly crunching the numbers in detail.


  1. A good exposition of the basic facts, RIT. I'd just commment that sometimes there are opportunity costs to consider, regarding capital versus expenditure. In the last example, it might be preferable to keep the £999. You might want to invest it or just retain it as part of an emergency fund.

    In my case, I resist paying off the residual £20k of my mortgage (currently 2.5%) because I prefer to use the cash elsewhere.

    1. Good point anonymous.

      Opportunity cost should always be considered when making any expenditure (or investment for that matter). It was something I previously highlighted with my Debt – Instant Gratification vs Long Term Wealth Creation post back in February but probably should have reinforced here.