Importance of Interest Points
What is the difference between a single percentage point of interest? Many people have problems grasping exactly how much a percentage point means. But the pound value of a percentage in interest is substantial, and a single percentage point can make a huge difference in how much you pay over time for the loan.
For example, a £10,000 loan at 6% interest over the course of 10 years adds an additional interest of £3,322. A 5% interest rate, however, has additional interest of only £2,728. That's a difference of almost £600 pounds due to only a single percentage point. And the amount increases by small increments over time. A 7% interest rate is a difference of over £600, and a 10% interest rate is over £2,500 more than a 6% interest rate.
The numbers add up, and finding a loan with a lower percentage rate can make a huge difference in the amount of money you are paying over time.
Importance of Loan Term
The loan term affects how much you pay as well. Let's look back at the example of a 6% interest rate. For a 6% interest rate over 10 years, the interest was £3322. However, if we had shortened that to only 5 years, the interest would have been only £1600 - less than half of the original interest.
The difference with loan term, however, is monthly payments. For the 5 year loan, the monthly payments must be £193.33, while for the 10 year loan the monthly payments were as low as £111.
Here is where your own personal budget comes in. If you can afford to make the higher monthly payments, then you want a shorter loan term because you end up paying significantly less overall. However, if you believe there is a chance you will not be able to make a payment if you choose the shorter term, you will want a longer term, despite how much you need to pay back, because missing a payment in many instances can bump up your interest rate, resulting in the significant increases we discussed earlier.