(MoneyHippo.com) – People have two options when they want to buy something they can’t afford to purchase entirely with cash: borrow the money or save up the funds for later. While seeking out a loan is a viable choice, remember that debt has two distinct parts — the principal and interest.
A loan’s principal is the amount of money someone wants to borrow. For instance, if you want to buy a car for $20,000, that represents the principal amount you would seek from a financial institution. The interest on the debt is the cost of borrowing the money. That amount adds to the principal periodically, using a percentage of the balance. In part, that’s how banks make their money. When a borrower pays their monthly obligation on the funds, part of the amount they remit pays toward the principal, and the other part pays toward interest.
Because the interest initially accrues based on the principal portion of the loan — the core amount of money the borrower requested — a good way to pay less, in the long run, is to pay down the principal as quickly as possible. Depending on the terms, a borrower could pay more than the monthly obligation and ask the bank to apply the extra money toward the principal balance. Doing so would more quickly lower the core loan amount, meaning the interest calculation would use a lower balance, saving the borrower money on the total debt.
Some people don’t realize the actual end cost when they borrow money. Assuming again that you borrow $20,000 for a car at a rate of about 6.2% interest over five years, that vehicle would ultimately cost over $23,300. The more you borrow and the longer the terms, the more you pay in the long run.
Before deciding whether to seek a loan, consider the overall cost and work to minimize that amount by paying down the principal faster, if possible.
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