Loans may be structured several different ways but the
two most important aspects to consider are the interest
rate (type and method) and the repayment schedule for the
loan.
There are two options to set your interest rate:
Fixed Rate: With a fixed rate the interest rate
(i.e. the percentage) applied to the outstanding principal
remains constant through out a predetermined period that
may or may not equal the length of your loan. The interest
rate is set at the beginning of your loan by examining the
risk involved and the current market rates. The advantage
of a fixed rate loan is that your interest rate is fixed
and the payments constant and they will not rise if the
market rate rises. The disadvantage is that you will not
benefit from a decline of the market rate.
Variable Interest Rate: With a variable interest
rate the interest rate applied on the outstanding principal
amount fluctuates in line with changes to the Bank Base
Rate or LIBOR and, as a result, so will the amount of your
payments. The interest rate for each period will be the
current market rate plus a predetermined premium that remains
constant throughout the life of your loan. The advantage
of a variable interest rate loan is that you save money
when the market rate decreases. The disadvantage is that
you are not protected from an increase in the market rate
and the interest you pay will increase with the market rate.
When deciding on your repayment schedule you should always
remember the longer you take to payback the principal the
higher your total interest payment will become:
"Equal" Payments: This type of loan requires you
to pay the same amount each period (monthly or quarterly)
for a specified number of periods. Part of each payment
goes toward interest and the rest goes toward principal.
After the specified number of periods you will have paid
back the entire loan plus all interest.
"Equal" Payment and a Final Balloon Payment: This
type of loan requires you to make equal monthly payments
of principal and interest for a relatively short period
of time. After you make the last instalment payment, you
must pay the balance in one payment, called a balloon payment.
Some lenders will give you the option to refinance the loan
to help you stretch out the final balloon payment. This
type of loan offers definite benefits to you. Because of
the lower monthly payments during the course of the loan,
you can keep more cash available for other needs. Of course,
when you are thinking about those nice low payments, don't
forget the big balloon payment waiting around the corner.
Interest-Only Payments and a Final Balloon Payment:
With this type of loan, your regular payments cover
only interest. The principal stays the same. At the end
of the loan term, you must make a balloon payment to cover
the entire principal and any remaining interest. The obvious
advantages of this arrangement are the low periodic payments.
But over the long term, you will pay more interest because
you are borrowing the principal for a longer time.
Single Payment of Principal and Interest: If your
lender agrees, you can promise to pay off the loan all at
once at a specified date. This payment includes the entire
principal amount and the accrued interest. Borrowing money
on these terms is best for a short-term loan.
Equal Principal Payments: This type of loan requires
you to pay the same amount of principal each period for
a specified number of periods. The total payment for each
period will be variable (and should decline) as you pay
interest only on the outstanding principal at the beginning
of the period. Borrowing money on these terms requires larger
payments in the beginning of the loan.
