There’s a famous quote that goes “there are only two guarantees in life: death and taxes”. However, we’d like to add one more thing to that list. One of the few guarantees in life is that you’ll probably need to take out a loan at some point in your life. Inevitably, you’ll probably need a loan for college, to buy a house, to buy a car, to start a business, etc.

When that time comes, it’s important to understand how your debt can impact your personal finances as a whole. To help out, we’ve put together this article to highlight how much your debt can really cost you.

How loans work 

First, we just want to say that there is absolutely nothing wrong with going into debt (or taking out a loan). Debt is a necessary evil and can help you get access to unique opportunities in life. However, before getting a loan, it’s important to understand how they work.

Here’s how they work: 

1. Banks (lenders) lend you money.
2. Over time, you repay the bank the amount that you borrowed plus an additional payment called interest.
3. The bank’s business relies on making profitable loans to people they think will be able to pay them back. That’s why they use metrics like credit scores, interview you, and ask you for lots of information before approving you for a loan.

It’s important to make sure that you’re receiving the best rate for your loan.

How much a loan can cost you

If you currently have any outstanding loans, and you’re paying interest on them, then you’re paying an interest higher than it should be and in the end,  paying back an unreasonable higher amount of interest than you should. In the world of finance, the difference between 1% and 2% is huge.

The difference between 2% and 6% is a catastrophe.

Consider the following example:

You take out a loan of $300,000 at a rate of 4% over 30 years (360 months). Ultimately you’ll pay $515,608 for the house. That’s $215,608 ($515,608 – $300,000) that you’ll need to pay in interest.

Let’s take a look at the same example with a slight tweak.

You take out a loan of $300,000 at a rate of 7% over 30 years (360 months). Ultimately you’ll pay $718,526 for the house. 

Everything is the same except for one thing: the interest rate. In this example, you paid 7%. By raising the rate just 3% you’re now paying $415,526 in interest!! You need to pay back more than double what you’re borrowing just because of 3%.

Steps to take 

Here are a few steps you can take to make sure that you don’t end up paying too much interest.

1. Work hard to fix bad credit or improve your credit score prior to applying for a loan.
2. Shop around and receive a few different options for loans (like you would for a car).
3. Meet all of your payments on time.
4. Pay down the principal as quickly as possible to lower the amount of interest you pay in the long run. The quicker you repay the principal, the less you’ll pay in interest.

If you do ever find yourself with overwhelming debt, do not worry. There are still plenty of options available to get out of debt. For example, debt consolidation is a very common method to consolidate debt together into one monthly payment with lower interest rates. There are also plenty of debt relief programs that you can explore.