The One BIG Mistake To Watch Out For When Comparing Loans

The online lending industry is becoming mainstream. If you have ever needed a loan for emergency or for refinancing your credit card debt, you must’ve heard about online lenders like Lending Club, Prosper, Upstart, and several others.

These companies make loans over the internet through an online application and some even give an instant decision in some cases. They are using technology to simplify and speed up the loan process. You can complete the whole process and get funds in your account without visiting a bank or talking to any human.

Online lenders charge origination fees to fund company operations and that’s a major source of revenue.

Online lending platforms make most of their revenue by charging what is called an “origination fee”. This is a fee that pays for the company’s operations — including the cost of acquisition, underwriting, and originating the loans.

In most cases, the origination fee is deducted from the loan proceeds before disbursement. This reduces the principal received and the fee is added to the interest rate as a percentage. This overall cost is known as APR (Annual Percentage Rate).

The APR may not be the best way to compare loan options if you are a high quality borrower who usually prepays the loan.

The Annual Percentage Rate gives consumers the ability to compare across multiple lenders. Generally, a consumer chooses a loan with the lowest APR. This makes sense. However, this may not be the best way.

Below, we explain how to really compare loans with the same APRs and why choosing a loan with the lowest APR may not be financially prudent.

Comparing Loan Options — How to Make the Right Choice

Let’s take three lenders, we call them A, B, and C. We will look at loan offers from all 3 of them and try to choose the best option.

3 Loan Options to Compare [Examples]

The lenders usually present their loan options as shown below:

Lender A:
Loan Amount: $10,000
Interest Rate: 10%
Loan Term: 36 months
Origination Fee: 5%
APR: 13.56%
Monthly Installment: $322.67

Lender B:
Loan Amount: $10,000
Interest Rate: 11%
Loan Term: 60 months
Origination Fee: 5%
APR: 13.26%
Monthly Installment: $217.42

Lender C:
Loan Amount: $10,000
Interest Rate: 11%
Loan Term: 24 months
Origination Fee: 3%
APR: 14.08%
Monthly Installment: $466.09

When comparing these three options, most borrowers will ideally go for the loan offer from Lender B. It has the lowest APR at 13.26% and payments seem more manageable.

The Mistake You Have to Watch Out For — APRs and Origination Fees

Even the lower-risk borrowers usually opt for safer options because they think that in any case, they can always prepay the loan without penalty.

Borrowers completely miss how a longer loan term impacts their APR and the total amount (interest + principal) they’ll pay in case of prepayment.

Total Finance Charge (financial term for interest+origination fee) in 3 cases:
Lender A: $2,115.80
Lender B: $3,545.24
Lender C: $1,486.20

It’s obvious to some people that the total interest charged will be higher in longer-term loans but they can reduce it by making additional payments every month. This definitely reduces the total interest paid but let’s see if it catches up to the shortest loan (which has the lowest overall interest charged).

Let’s consider 2 cases of extra payments with the loan offer from Lender B:

Case 1:
You pay $105 extra every month such that the loan is completed in approximately 36 months. If you do the math, the total finance charge you pay in this case is $1,817.82 (interest)+ $500 (origination fee) = $2,317.82

Case 2:
You pay $235 extra every month so that the loan is paid off in approximately 24 months. If you do the math, the total finance charge you pay in this case is $1,075.61 (interest)+ $500 (origination fee) = $1,575.61

As you can see in this case, prepaying the loan in 24 months is ~$100 more expensive even with a lower APR.

Many borrowers make decisions based on just APRs thinking they’ll prepay the loan and the total interest they’ll pay will be lower. Unfortunately, this is not the case with loans that have high origination fees and longer repayment terms.

Conclusion

To sum it all up, calculate everything! Don’t assume that you’ll be able to prepay and avoid interest, because origination fees will sneak up on you.

When comparing loan options, make sure you do comprehensive calculations to make sure you are getting the best deal. There are many loan calculators available online to make it easy for you to compare.

Stilt charges one of the lowest origination fees in the industry because we have optimized and automated our loan operations in a cost-effective way. This allows us to offer shorter terms without increasing the APRs for our borrowers.

Frank Gogol

I’m a firm believer that information is the key to financial freedom. On the Stilt Blog, I write about the complex topics — like finance, immigration, and technology — to help immigrants make the most of their lives in the U.S. Our content and brand have been featured in Forbes, TechCrunch, VentureBeat, and more.

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