“Affordable loan: what and why”, “Who would you advise me to contact?”, “And if you do not want insurance?”
After 14 years in banks, banking groups and similar you automatically become the trusted advisor of relatives and friends who ask you for the most disparate financial issues . One of the most complicated questions that can happen is to understand if a loan is cheaper than another .
With its constant installment, the loan has a simple and soothing aspect that leaves nothing of the underlying complexity.
Just do a search in Google to come across lists of 3 (or 5, or 6) tips on how to choose loans with questionable content, such as advice to increase the loan term to make it more sustainable. As we will see the various criteria for comparing a loan is not simple, but longer durations are much more expensive for the consumer and must be considered carefully.
For some years now the parliaments of the European countries have approved uniform rules on the information to be provided for the choice of a loan. It is mandatory to always show three indices for the comparison:
- the annual net rate (TAN)
- the annual effective annual rate (APR)
- the total amount due.
At this point, the classic article like “5 reasons on how to choose a loan” says that all the criteria are important but the APR is the best because it takes into account all the components of expenditure.
Instead, we go against the mainstream and say first of all that a rule that imposes 3 criteria of choice for consumers does not interest them but only increases the confusion. Anyone who has thought the names of the indicators should do a communication course.
As for the three criteria, one is superfluous, one is misleading and only one is really useful. And it’s not the APR.
Obviously, this is our opinion and we recommend that you compare several before deciding.
Keeping in mind that everyone who writes on internet loans has some kind of interest, as we do, we manage a private loan marketplace .
Before going into the details of what you need to look at to evaluate their convenience, we must make a brief introduction on how a loan works . A bit ‘to clarify the following concepts and a little’ to make Google happy, which is a piece of blog as a traditional publisher to a book: gives you advice that is best to follow, if you want someone to read.
For readers who already know what a loan is or do not want to go into details, we recommend simply skipping the paragraph.
Cheap loan? First we’ll clear up how a loan works
All loans offered on the Italian market are at a fixed annual nominal rate and constant monthly payment . This means that every month repay the same sum, the monthly payment, which is made up of
- interest calculated according to a fixed percentage (nominal annual rate)
- repayment of the financed capital.
As the capital falls a little bit each month, the interest payable falls accordingly. The constant installment therefore hides interest that continuously falls and the return of the ever-increasing capital . It’s the magic of constant or French depreciation plan.
For example, we take a loan of € 4900 + € 100 of commissions and an interest rate of 6% per annum (or 0.5% month which is the same thing). The commissions are financed together with the loan and the duration is 3 years.
The customer’s installment is € 152.11 (and here it is worth trusting that the calculation of the installment is too complicated to explain it in this space!).
The first installment will consist of € 25 of interest (0.5% x € 5,000) + € 127.11 of capital and at the end of the first month the customer will still have to return € 4,872.89 (ie the initial € 5,000 minus 127, € 11 which returned in the first installment).
The second installment will consist of € 24.36 in interest (less than before, because the capital is less) + € 127.75 in capital, and so on for subsequent installments.
The elements that impact on the installment of each loan are therefore:
- the financed capital (the sum borrowed)
- the nominal annual rate
End? Unfortunately no, there is another element to keep in mind, l and other expenses and commissions to be paid.
And this is what makes comparing the various loans difficult.
Convenient Loan = Lower Installment?
The first thing we all look at in a loan is the installment , which is how much the loan will cost each month. That’s right, because the first question to ask is whether a loan is sustainable compared to monthly income . If it is not, the best way to lighten the weight is to increase the duration, which allows you to lower the installment.
Looking only at the installment, however, is not sufficient to judge the convenience of a loan or to compare different loans to each other.
First of all, the installment does not necessarily include all the commissions : for example, some operators charge an initial commission separate from the installment, while others (almost all in truth) add some expenses to each installment, such as collection.
Even in loans which the installment includes all the expenses, there is however a problem: as the loan lasts, it is true that the installment is always smaller and more sustainable, but the overall cost increases : how is it? logical, if I borrow money for more time, I pay more interest.
Increasing the duration to improve sustainability therefore has a cost and evaluating a loan only on the basis of the installment does not give a real idea of the expense.
We take back the loan of the previous example and try to lower the installment. Extending the term to 5 years the installment would fall to € 96.66. A big difference in terms of sustainability.
However, we look at the sum of all the installments, that is, how much you pay in total the loan. With a 3-year term, the expense would have been € 152.11 x 36 = € 5.476, which would become € 96.66 x 60 = € 5.800 at 5 years. A difference of € 323 that can be perfectly logical to accept in the face of the reduction in installment, but that certainly is not obvious looking only at this.
How then to understand if a loan is convenient and to compare it with others??s??
The superfluous, the misleading, the useful
Let’s go back to the indicators required by the legislation: TAN, TAEG, total amount due.
The TAN is the percentage rate at which the loan is made (in the case of private loans it is the rate that our investors receive each month). It would be sufficient to look at it if the loans had no other cost beyond the interest rate; however, since all loans have some kind of expense or commission, it does not say anything by itself. It’s useless and we can forget it.
The TAEG instead corrects the defect of the TAN because it is the rate that includes all ancillary costs and is sophisticated enough to “weigh them” differently depending on when they are paid. Noble intent. However, in most cases these costs take place at the beginning of the loan and in the calculation of the APR they are spread over the entire duration. This means that as the duration increases, the APR falls, giving the illusion of a cheaper loan. But as we had already seen in the case of the installment, it is not so. On the contrary, as the duration increases , the interest to be paid and therefore the expenditure increase . This indicator is not just useless, it’s just misleading.
The total amount due on the other hand does not have any of these defects . As the name suggests, it includes all the sums that must be returned for interest, principal repayment or other payments. Compared to the APR it has the defect of not weighing the temporal structure of the flows, it does not make differences based on when a certain sum is paid.
It is therefore a raw indicator, compared to the APR is a little ‘the criterion of the farmer with big shoes and a fine brain. Brain up because seeing that it includes all expenses provides an exact and very concrete metric of exactly how much a loan will cost.
The purists will object that not considering the temporal structure of the flows is serious, but since the loans tend to have similar structures and that any comparison is made difficult by the lack of a discount rate to us this seems a minor flaw.
To better understand what we are talking about, let’s take the example we made at the beginning of the article:
- the TAN is 6%
- the APR 7.62%, a little higher than the TAN because it also includes the € 100 commission
- the total amount due 5,476 € = 152,11 € X 36. The loan therefore costs € 576 = € 5,476 – € 4,900
Let’s see what happens if the customer tries to reduce the duration, for example at 24 months:
- the installment becomes € 221.6
- the TAN remains equal to 6%
- the APR rises to 8.29%
- the total amount is reduced to € 5,318 = € 221.6 X 24 , in line with what the intuition suggests: if the loan lasts less, I pay less interest.
So by recapitulating, as the duration and therefore the cost of the loan decreases, the TAN does not even notice it and remains stationary, the TAEG even rises. As we said, an indicator is superfluous and the other is misleading.
And it is certainly not a case: in the graph below we have drawn the trend of APR and total amount due in the case of our loan-example. As we said, as the duration increases, the APR falls while the total amount goes up .
APR and total expenditure by duration
Another thing that is clear from this graph is the extreme sensitivity of all these indicators with respect to duration . It is therefore a good idea to try and separate the comparison between loans other than the choice of duration. It is better to understand first of all on which duration to orientate and then compare different offers for the same duration .
Transparency where you are
It’s not over. There is also another reason why the total amount due is a better indicator . If I asked you to check if our calculation of the total amount due is correct, multiplication would suffice. Instead, try to calculate the APR without using a special software. It’s impossible.
This element is not irrelevant: we often deal with expenses not considered in the APR but which we want to take into account. A classic example is the expense for the collection of each installment (from € 2 to € 5), or the cost of that insurance policy that we do not feel the need but that we are strongly recommended to take when we sit in the office of a financial. Well, in these cases to recalculate the total amount due just a simple calculator, while to recalculate the APR would serve ” A beautiful mind ” …
The 4 tips to choose the most convenient loan
Finally, we try to distil our conclusions into a simple list of 4 tips to find a convenient loan:
- look at the installment to understand if the loan is sustainable and the total amount due to understand how much it will cost . Ignore everything else
- check that all expenses are present in addition to the installment and if not add them by hand . Pay particular attention to the payment of installment fees, the paper statement, insurance policies
- try to reduce the duration in order to spend less , of course without forgetting to keep it sustainable compared to your income
- tries to compare the different loan offers for the same duration .