Consumer loans have helped a lot of people to salvage financial situations that their income could not take care of. That is why banks and financial institutions will always have multitudes apply for them on a daily basis. On the other hand however, a good number of people have been plunged into debt because of this same financial product. One reason for this is a lack of full understanding of what the whole process entails.
Many people sign off on an agreement for a credit facility without understanding the full import of the contract. They are excited about having money in their account and meeting the urgent need that they have but when the time comes for them to pay, they discover that the amount they are repaying is far more than they envisaged.
For this reason, it is important that before applying for credit, you understand some basic terms. Similarly, when you start an application process, find out all that it entails before signing the agreement. Therefore in this article, we will focus on two terms that you need to get a full understanding of and they are nominal and effective interest rates.
We will explain these two terms, the difference between them and other terminologies that will most likely be in a loan agreement.
So stay with us as we proceed…
What is Nominal Interest Rate?
This is the interest rate on a credit facility before inflation is taken into consideration. It can also mean the rate that was advertised on the offer without adding the extra fees that accrue to it or its compound interest.
These rates are set by the central bank of a country on a short term basis and they are the basis on which financial institutions and banks fix other rates. Although a nominal rate is what a consumer will see at face value on the loan agreement, which is not actually what the person will pay at the end of the day.
You can check out: forbrukslånlavrente.com/forskjell-på-nominell-og-effektiv-rente/ for more on nominal interest rates.
Where are Nominal Rates Used?
You will most likely see nominal interest rates advertised on offers for loans or investments that you expect to give you return on investments. Other interest that you will see on these offers include APY (annual percentage yield) and APR (annual percentage return). These rates put into consideration factors such as the effect that compounding interest has on a credit and other additional costs and fees.
What Is Effective Rate?
This is what the consumer actually pays at the end of a year. This rate includes the nominal interest, establishment fees, instalment fees and every other cost that is embedded in the credit. This rate is usually higher than the nominal rate as it should be because it includes all the extra fees and costs.
The amount that this rate comes up to depends on the costs of the additional fees. Another factor that affects the effective rate is the duration of the credit facility.
Factors to Consider Before Signing Off On a Loan Agreement
Like we mentioned earlier, anyone seeking to take out a loan must be intentional about understanding all the terms and conditions. Do not sign off on any loan agreement if there is any terminology or clause that you do not understand. You may even need a lawyer to look at the agreement before you sign; this is essential for credit facilities such as mortgages.
There may be instances where you may not have time to have a lawyer look through your loan agreement. Therefore we will share some tips on what to look out for in a loan contract:-
Interest Rate
Consumers seeking to get the best deal from a consumer loan may be confused when comparing options. This is because some people just look at the nominal interest rate without checking the effective rate. The confusion caused by this omission usually leads to accumulation of debts by borrowers.
For this reason therefore, consumers are advised to consider both rates but to focus more on the effective interest rate. This is especially if the nominal rates of several loan options that you are considering are the same. This will help you determine which loan is the ‘cheapest’.
Cost of the Loan
No matter the type of facility that you are looking for, they all have costs which include interest rates and associated fees. This therefore means that you cannot just look at the rates whether nominal or effective. You have to make sure that you know and understand every cost that the credit facility comes with.
Bear in mind that loans without collateral are usually costlier in terms of fees and other costs than those with collateral. This is because the collateral mitigates the risk of the credit facility for the lender.
Factors that affect what a loan will cost at the end of the day include the following:-
- Interest rate and fees
- Repayment duration
- The bank/lender
Most often, you may not be able to calculate the total cost of a credit facility without help. Therefore, it is recommended that you use a loan calculator to give you a near accurate estimation of the total cost.
Repayment Duration
The length of time that you have to pay your debt determines how high the interest rate will be. Longer repayment periods often attract higher rates (especially effective interest) than shorter repayment duration.
Prepayment Penalties
These are fees that the lender will charge if the borrower pays off the money earlier than the agreed end of the loan term. This is usually stated in the loan agreement therefore you should look out for it
You may wonder why you should be punished for paying off a loan earlier than stated on the agreement. Understand that lenders who give out credit facilities make their profit from the interest on the loan and other fees that you pay. So let’s assume that you have a credit facility with a term of 10 years and you pay off in 4 years, you have made the lender to lose 6 years of profit from the interest that would have accrued on the loan.
Click here for more information on this and the previous point raised.
Negative Amortization
This is the amount that is added to the balance that’s outstanding when your payment for a month doesn’t cover the interest due for that month. Therefore you need to check that clause or condition to be sure that you are ok with it before signing the agreement.
Delinquency Penalty
Delinquency is the term used to describe missing the due date of a single payment. Every loan agreement will have this clause so you need to look out for it and be sure you understand it.
Default
Default is the number of consecutive payments that a borrower will miss that will result in consequences. These consequences include legal actions against the borrower or repossession of the collateral presented in the case of secured loans. Some banks have their default set at 3 months but this varies from one bank to the other.
ACH Payments
This is the situation where the lender is authorized to pull the monthly payment straight from the borrower’s bank account. This condition usually comes with an incentive of a reduction in the interest rate of the loan.
Mandatory Arbitration
This is a clause that forces the borrower and the lender to resolve any form of dispute privately. Private dispute settlement is usually done through an arbitrator rather than the court system. In cases of private arbitration whatever the professional conflict decider rules stands as final verdict.
This condition might not be favourable to you as the borrower, therefore, you have to note it and either agree or disagree to it before the final signing.
Conclusion
There are so many terminologies that one will find in a loan agreement. One of them is nominal interest rate. We have explained what it means and even went on to explain other terms and factors to consider before you sign off on a loan agreement. Bear them all in mind so that you will not enter blindly into any agreement.
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