Taking out a loan is not something anyone would prefer but sometimes it becomes unavoidable. There could be many reasons why you have to take a loan at some point. But it comes with certain pros and cons.
When considering taking a loan, there are some things which should always be kept in mind. First and foremost is the repayment terms including things like accumulated interest and capital payment over time. Knowing this may help you better manage your loans.
But sometimes, your total loan balance may increase your total owed balance and that is not something a borrower would want. There are certain factors which lead to this situation. This article will explain how and what increases your total loan balance.
Before moving on to the factors which increase your total loan balance, let us first understand how loan balance works. To understand your loan balance, it’s important to recognize that the total amount a borrower owes on an instalment loan typically surpasses the initially borrowed sum. This happens because lenders commonly impose interest on top of the principal loan payment.
Now, following key concepts should always be known beforehand.
- Principal Amount: This is the original sum of money borrowed.
- Interest Rate: It signifies the rate at which the lender charges the borrower for access to funds that are borrowed.
- Annual Percentage Rate (APR): The APR represents the total cost of borrowing, that includes interest, fees, and additional charges.
- Fees: These are supplementary charges associated with borrowing money, such as origination and payment processing fees.
- Loan Balance: The remaining amount of money that the borrower still needs to repay.
Factors which can increase total loan balance
Interest Rate:
When you borrow money through a consumer loan, the lender attaches an interest rate to it. This interest rate determines the extra amount you need to pay back on top of the loan amount. Sometimes, the interest can increase over time through a process called interest capitalization. This means that if you don’t pay the interest right away, it gets added to your loan balance, and future interest is calculated on this higher total.
Your annual percentage rate (APR) is not exactly the same as your interest rate. The APR includes the interest rate and other fees related to the loan origination.
Interest capitalization happens when unpaid interest is added to your loan amount. Normally, the interest is part of your monthly payment, but there are situations, like loan deferment or forbearance (commonly seen with student loans), where interest may go unpaid and keep adding up.
In these cases, lenders might add the unpaid interest to your loan balance. This can make your total owed amount, as well as your monthly payment, go up, along with the overall interest you pay in the end.
Variable Interest:
A variable interest rate can change over time, often linked to a benchmark or market index. This feature can be appealing when interest rates are low, but it comes with the risk of higher interest costs if rates increase. Credit cards commonly have variable rates, and carrying a balance may lead to growing debt if rates go up.
Variable interest rates, also called adjustable rates, can go up or down based on market trends. Take adjustable-rate mortgages (ARMs) as an example. If borrowers make minimum payments on a payment-option loan or have a payment cap, their total balance may rise.
A payment cap sets a fixed monthly payment, and if it doesn’t cover increased costs due to rising interest rates, the unpaid interest might be added to the principal balance. Similarly, payment-option loans let borrowers choose different monthly payment options, but if minimum payments don’t cover the total interest, the unpaid amount may be added to the total balance.
Making the Minimum Payment:
Choosing to stick only to the minimum monthly payment may seem convenient at the time but it is not advised in the longer run. This approach carries the risk of paying less than the monthly interest accrued.
Consequently, if the interest charges surpass your minimum payment, your loan balance will increase. While the minimum payment may align with your budgetary situation at that time, it may lead to a growing loan balance over time.
Making Late Payments:
Submitting a late payment incurs an immediate late fee, but the repercussions extend beyond that. The loan balance continues to accumulate interest, contributing to a larger overall balance.
Consistently making late payments can significantly impact the growth of your loan balance, posing financial challenges over the long term.
Missing a Payment:
Missing a payment comes with its consequences, the foremost among them being the heightened risk of loan default. In addition to this major concern, skipping a payment provides an opportunity for your loan balance to expand further.
Although the initial loan balance remains unchanged without the payment, the missed opportunity allows interest to accrue on a larger loan amount, resulting in a swift and considerable increase in the overall loan balance.
Fees/Penalties:
Borrowing money also comes with various fees, including payment processing, account maintenance, and application charges. Among these, late fees are common and costly.
If you miss a payment deadline, it may incur a late fee, which is often added to the next month’s statement along with additional interest.
Bottom line:
While taking a loan may seem convenient to ease your financial burden at times, it sometimes becomes unmanageable while paying it off. So, to avoid any increase in your total loan balance, the above mentioned factors should be carefully analyzed before taking out a loan.