The Cost of Credit: How Much Are You Paying to Borrow?

By Upstart Content Team | Updated December 21, 2021
reading time 7 min read
A man sits at his computer and calculates the cost of credit

Key takeaways: 

  • The cost of credit is the money you pay in exchange for access to financing, like a personal loan or credit card. 
  • Interest rates, loan terms, the amount of debt, and additional fees can drive up your cost of credit. 
  • Lowering interest rates through a debt consolidation loan or credit card refinancing loan can help reduce the cost you ultimately pay for borrowing. 

Debt can feel like an unavoidable part of life for many American consumers. Whether you want to buy a home, go back to school, or make a big purchase, personal loans, mortgages, and credit cards can make the process easier.

But the convenience of credit can come at a hefty cost. If you’re not careful, it’s easy to get caught in a cycle of revolving credit, minimum monthly payments, and high interest fees.

In this guide, we’ll look at the true cost of credit and break down the factors that influence this number. We’ll also discuss ways to reduce your cost of credit so you can improve your financial health. 

What is the cost of credit?

The cost of credit is the money a lender charges when providing you—the borrower—with access to financing. You can think of it as the rent or convenience fees you pay to use your lender’s money for a period of time.

Your cost of credit may vary depending on your loan provider and the type of financing you currently use. It can include costs such as interest, origination fees, or taxes. 

Typically, the cost of credit describes the total amount you owe after these additional charges are added to your original balance. Then, they’re broken down into monthly, quarterly, or annual payments. 

Why does the true cost of credit matter?

The total cost of your existing credit paints a clear picture of your financial health. For instance, understanding the costs associated with your existing debt—including the interest and charges it accumulates each month—can help you track how much you owe your creditors. 

Determining your full cost of credit can help you visualize the true cost of a loan or recognize how much credit cards cost in the long run. 

It can also help you understand how credit impacts your finances and if you can afford to take on more debt.

We’ll take a closer look at how to calculate the cost of your credit below. But first, let’s get familiar with the factors that impact the cost of credit. 

Factors that impact the cost of credit

The 5 factors influencing your total cost of credit are: 

  • Interest rates
  • Total debt
  • Credit terms
  • Monthly payments
  • Additional charges and fees

1. Interest rates

Interest may be one of the most influential factors in determining the cost of your credit. Interest is the money you pay in exchange for access to credit. It’s usually expressed as a percentage. Your lender may also refer to interest as your annual percentage rate (APR)

It’s easy to confuse the two terms, but an APR is slightly different than your interest rate. An APR includes the total amount of interest you’ll pay each year plus fees like closing costs, origination fees, and other charges. APRs are calculated based on factors like the total amount borrowed, your repayment schedule, and additional financing charges.

True cost of loan example

Interest charges are usually tacked onto your monthly payment. For instance, imagine you need to make a $1,000 purchase. You take out a $1,000 personal loan with a 5-year term and a 20% interest rate

The monthly payment on your loan principalor the $1,000 you borrowed—would only be $17. However, you’ll pay $589 in interest over the life of the loan. 

This breaks down to about $10 per month, making your monthly payments roughly $27. Paying an additional $10 per month may not seem significant, but by the time you repay your loan, your credit cost will reach $1,589. This amount is over 50% more than you originally borrowed.

2. Total debt

The amount of money you owe will impact your total cost of credit. Consider the example above. You still make the $1,000 purchase. Instead of financing the total amount, you put down $400 in cash and finance the remaining $600.

The terms are the same: a 5-year repayment period with a 20% interest rate. But because you only took out a $600 loan, your monthly payment will drop to $16. You’ll pay $354 in interest and reduce your total cost of credit to $954.

3. Credit terms

Did you know the repayment term of the loan or credit line can affect your total cost, too? Typically, shorter terms come with higher monthly payments because you shorten the repayment period. However, you’ll likely pay less in interest and fees. 

On the other hand, longer terms usually come with lower monthly payments because the installments are spread out over a longer period. But it can come at a price. Most of the time, long-term financing has higher interest rates because you’re “renting” the money from your lender for longer.

Let’s revisit the personal loan example above to compare total interest costs for a 5- and 10-year repayment period.

5-year (60 month) loan 10-year (120 month) loan
Loan Amount: $1,000

Interest Rate: 20%

Monthly Payment: $27

Total Interest: $589

Total Cost of Credit: $1,589

Loan Amount: $1,000

Interest Rate: 20%

Monthly Payment: $19

Total Interest: $1,318

Total Cost of Credit: $2,318

4. Monthly payments

So far, we’ve discussed how interest rates, repayment windows, and total debt affect loan payments. However, these factors affect credit card debt, too. With American consumer debt on the rise, it’s more important than ever to understand how the details of your debt impact your financial health. 

Some types of credit—like personal loans—tend to come with fixed monthly payments. That means you’ll know how much you’ll pay every month. That’s not always the case with credit cards. 

Depending on your spending habits, goals, and financial circumstances, you could pay off the balance each month. Or you may choose to revolve your credit and make partial or minimum payments. 

True cost of credit cards and minimum monthly payments

The typical minimum payment is about 2% of your total balance. To get a better idea of how much a 2% minimum payment can cost you, let’s revisit your $1,000 purchase. 

Instead of using cash or a loan to make the purchase, you use a credit card with an APR of 18%. Your minimum monthly payment is 2% of the balance, or $20. 

Nearly $15 of your $20 payment will go directly to your interest. That’s why it’s so easy to get caught in the minimum payment trap. Even though you’re making regular payments, most of it goes toward your APR instead of your principal. 

As a result, you’ll need over 7 years to repay the $1,000 balance. At the end of the 94 months , you will have paid $862 in interest, driving your total cost of credit up to $1,862. 

Your expenses have nearly doubled. What’s more, they don’t even include annual credit card fees, which cost $94 per year on average. When you add those in, you could spend more than $2,500 on a $1,000 debt.

5. Additional charges and fees

Finally, it’s important to review additional charges and fees that can increase your cost of credit. It’s easy to miss these fees without reading your credit terms carefully. They can appear unexpectedly, too. For instance, some creditors charge prepayment penalties if you get ahead of your loan payments. Others may include an annual maintenance or membership fee. 

Keep an eye out for common charges and fees, including: 

      • Application fees
      • Origination fees
      • Account maintenance fees
      • Loan commission
      • Late fees
      • Overdraft fees
      • Rate increases
      • Membership fees

How to calculate the cost of credit

You can use a personal loan calculator or credit card calculator to determine the true cost of your credit in a few easy steps. Or you can calculate the cost of your credit manually using the following formula:

      1. Divide your APR by 365 to get your daily interest rate. 
      2. Multiply the daily interest rate by 30 to get your monthly rate. 
      3. Finally, multiply your monthly rate by your total balance to calculate your monthly interest payment. 

Using this formula with our previous example, we would divide our APR of 18% by 365 to get a daily interest rate of about 0.05%. In step 2, we would multiply 0.05% by 30 to get our monthly rate of 1.5%. Lastly, we would multiply our monthly rate of 1.5% by our total balance of $1,000. This will give us our monthly interest payment of about $15. 

How to reduce the cost of credit

Reducing your cost of credit can have several advantages, from boosting your monthly cash flow to improving your debt-to-income ratio. The trick to reducing your cost of credit is to lower your interest rates, which you can do in a few ways: 

Consolidate your debt

Debt consolidation involves combining several types of debts into one payment by taking out a loan, like a personal loan. Once you accept the loan, you’ll receive the funds in a single lump sum. You can use the funds to pay off each balance, then begin making monthly payments on a single loan instead of juggling several credit lines.

Refinance high-interest credit card debt

Credit card consolidation, or credit card refinancing, only applies to revolving credit card debt. With this method, you combine the balances of several credit cards into one. 

If you have a solid credit score, you could qualify for a credit card consolidation loan with a low, fixed interest rate that won’t change throughout the life of the loan. 

Improve your credit score

Your credit score works like a financial grade, measuring how well you’ve repaid past debts. If you have a history of repaying debt on time and in full, you’ll likely have a higher credit score. Missing payment deadlines—or skipping payments altogether—may lower your credit score.

It’s important to have a good credit score because it helps lenders gauge your financial reliability, or your creditworthiness. Credit scores play a huge factor in determining whether you will qualify for credit and, if so, the interest rates you’ll get.

Getting a lower interest can help reduce the total cost of your credit. To improve your chances of qualifying for a low interest rate, take steps to improve your credit score. You can get started by making timely payments on your existing debt. You can also check your credit report for any outstanding payments or errors hurting your score.

Repay debt faster

If your budget allows it, try making extra payments to minimize your cost of credit. In addition to saving on interest, you could close out your balances faster.

Be aware that some lenders charge a prepayment penalty for paying off a loan too soon. To avoid surprise fees, check with your lender or review your loan agreement before you use this method.

Improve your financial health by understanding the true cost of credit

Credit is a convenient and necessary part of life. But without careful management, it can become expensive quickly. Fortunately, understanding the cost of credit can help you get a better idea of how it affects your financial goals. 

It also empowers you to make smart financial decisions, like consolidating debt or refinancing high-interest credit. As a result, you can budget more effectively, improve your credit, and take the first steps toward a happier, healthier financial future. 

This content is general in nature and is provided for informational purposes only. Upstart is not a financial advisor and does not offer financial planning services. This content may contain references to products and services offered through Upstart’s credit marketplace.

About the Author

Upstart Content Team

The Upstart Content Team shares industry insights, practical tips, and borrower success stories to help people better understand the important “money moments” of their lives.

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