Loans and loan costs

Credit and loan

Credit – usually a loan – is money that a person borrows from another person, committing themselves to pay it back in full, plus the agreed interest, at the agreed date(s). The word credit derives from the Latin “credere”, which translates as “to trust” or “to believe.” The person that lends the money – the creditor or lender – trusts that they will receive the money plus interest back from the borrower after the agreed period of time.

The duration, costs and other terms and conditions of the credit (in most cases: a loan) are usually set out in writing in an agreement.

Interest on loans

Interest can be understood as the price paid by the borrower and received by the lender for the transfer of money. This price is expressed by the interest rate as a percentage of the borrowed amount. The interest rate is always specified for a certain period of time (e.g. 3% for one year: 3% p.a.) so that it is possible to apply it to different amounts and make comparisons.

Lenders charge interest because they have to bear certain risks and costs:

1. They are unable to use the money they lend out during the term of the loan.
2. They cannot be sure that they really get their money back (dubious risk).
3. The value of money may change during the term of the loan (monetary value risk).

When comparing loan offers, it is important to distinguish between the lending or nominal interest rate and the effective annual interest rate. For example, a person takes out a loan at an interest rate of 3% p.a. (= lending or nominal interest rate). But since there are also administrative fees and other costs, the actual costs of taking out the loan are higher than 3%. The effective annual interest rate takes all these costs into account and, hence, shows the total costs of the loan, in contrast to the lending or nominal interest rate. When shopping for a loan, it therefore makes sense to compare the effective annual interest rate of loan offers.

Factors influencing the interest rate

Comparing loan offers is important because different lenders charge different interest rates. When a bank lends out money, the interest rate depends on 

• how much the bank itself has to pay for borrowing money (that is, the bank’s refinancing costs); the EURIBOR (Euro Interbank Offered Rate) is the rate at which banks in the euro area can borrow money from another bank. It is often used in many loans as a reference rate for calculating the applicable interest rate.
• how risky the loan is considered to be (risk costs);
• what costs the bank needs to cover (e.g. operating costs, costs of customer counseling, management) and what the bank’s profit should be.

Fixed vs. variable interest rate loans

The level of interest rates, both for banks and customers, is closely linked to the general economic situation and the general interest rate level. Since the latter may vary, interest rates also fluctuate over time. This is why, when taking out a long-term loan, you should remember that the interest level may change over the term of the loan.

A loan can be taken out at a fixed or variable interest rate. One way to avoid the uncertainty of future interest rate developments is to opt for a fixed interest loan, where the interest rate remains the same for the agreed term. In a variable rate loan, the interest you pay depends on the general interest rate level, or, more precisely, on the reference interest rate specified in the loan agreement. Often, the EURIBOR is used as the reference interest rate.

Depending on the future development of the general interest rate level, either the fixed or the variable interest rate is better for the borrower. If the general interest rate level rises, the borrower with a fixed rate loan will be at an advantage because the interest rate on their loan remains the same. If the general interest rate level falls, by contrast, the borrower with a variable rate loan will be at an advantage: the interest rate on their loan will be adjusted to a lower rate. The chart below shows an example with three scenarios and their impact on the loan installment.

Repayment and term of a loan

A loan is usually repaid in equal monthly installments, which include the repayment of the borrowed amount (the principal) and interest.

The overall cost of a loan also depends on its term (that is, its duration). As interest is always charged on the outstanding principal for the remaining term, a longer term means higher overall costs. In other words, while the monthly installment may be lower, a longer term entails higher overall interest payments. Shorter loan terms, by contrast, mean lower overall costs, with higher monthly installments. So the decision about the term of a loan also depends on the financial situation of the borrower.

Collateral

Lenders bear the risk that borrowers may not be able to make repayments as agreed. The lender covers this risk by checking the borrower’s credit standing, that is, their ability to pay back a loan, before granting a loan. To this end, the lender, usually a bank, collects information about the borrower’s current income and assets (e.g. real property, life insurance policies). In addition, the bank puts together an overview of the borrower’s current expenses (e.g. rent, energy costs, insurance premiums) and compares them to their current income. This helps the bank determine whether the borrower has sufficient funds to make regular loan repayments or whether the repayments would leave the borrower too little money to cover their basic necessities. Moreover, the bank checks whether the borrower has previously taken out and repaid loans, whether they have outstanding loans or whether the borrower has (previously) overdrawn their bank account.

That said, it still happens that a loan defaults, despite all controls and checks. A borrower’s income situation may deteriorate through unforeseeable events (such as job loss, divorce or sickness). For this reason, banks protect themselves against losses caused by the default of loan repayments by requiring the borrower to provide collateral.

Considerations before taking out a loan

Budget planning

Taking out a loan comes with a number of obligations (especially the repayment of principal and interest) over a longer period of time. Therefore, as with all money matters, you should think carefully whether you can afford this type of financing. You need a budget plan to find out whether you are able to pay back the money you borrow. In addition to listing current income and expenses, you should take into account that your financial situation may change, due to, for example, income losses or unexpected expenses. Make sure to have reserves that can be used if necessary. If several people take out a loan together, they should make arrangements that set out how the loan will be dealt with if there is a dispute or a borrower leaves the loan agreement early.

Comparing loan offers   

Before signing a loan agreement, make sure to compare several different offers. Lenders are obliged under the Consumer Credit Act to inform potential borrowers about

• the total loan amount
• the nominal interest rate (lending rate)
• the effective interest rate
• the term of the loan
• the total costs (loan amount plus all other costs)

Total costs and the effective annual interest rate are best suited for comparing different loan offers.

Term of the loan and duration of use

Any loan you take out should be in healthy proportion to the value of the product or service you buy. If, for example, you buy short-lived consumer goods like mobile phones, games consoles, etc. or a package vacation on credit, it may well be that you are still paying off your debt when the vacation is long over or the phone is no longer working. Therefore, the term of the loan should generally not be longer than the duration of use of your purchase.