Your total loan balance increases primarily due to factors such as borrowing more money, high interest rates, making late or minimum payments, accruing hidden fees, and failing to control unnecessary expenses. Additionally, economic changes like inflation and opting for longer loan terms can also contribute to a growing loan balance.
Understanding the dynamics of your total loan balance is crucial for responsible financial management. Whether you have a mortgage, student loans, auto loans, personal loans, or credit card debt, the factors that can increase your total loan balance are varied and significant.
In this article, we will explore these factors and their implications, providing a balanced perspective to help you make informed decisions about your loans.
Key takeaways:
- Factors like interest rates, loan terms, inflation, missed payments, and refinancing can increase your total loan balance.
- If you want to reduce your loan balance, consider early repayments, debt consolidation, or seek professional advice for a repayment plan tailored just for you
- When talking about total loan balance, it’s essential to consider the effect of compounding interests and how they become more pronounced over longer loan terms
- According to a recent Bankrate study, an average American consumer can take out a personal loan at an 11.43% interest rate
What is your total loan balance?
Calculating your total loan balance involves considering several factors, and the exact method can vary depending on the type of loan you have. Here’s a general overview of how it’s calculated:
- Principal amount: This is the initial amount you borrowed. Your loan balance starts with the principal.
- Interest: The interest is the cost of borrowing money and is typically expressed as an annual percentage rate (APR). To calculate the interest, the lender applies this rate to the outstanding principal balance. The interest you pay decreases as you pay down the principal.
- Accrued interest: If you have a loan with compounding interest, interest accrues on both the principal and any unpaid interest. For example, if your loan accrues interest daily, the lender calculates a daily interest amount.
- Additional fees: Some loans come with fees, such as origination fees or late payment fees. These fees can add to your total balance.
- Payments made: As you make payments on your loan, a portion goes toward reducing the principal, and the rest covers the interest and fees. The amount applied to the principal increases over time.
- Missed payments: Missing payments can result in additional fees and interest, increasing your total loan balance.
- Loan term: The length of time over which you’re repaying the loan affects your total balance. Longer terms mean more interest paid over time.
What increases your total loan balance?
A loan can be a valuable financial tool, but if not managed properly, it can become a burden – in this sense, understanding which factors can increase your total loan balance is crucial.
1. Interest rates
Interest rates represent the cost of borrowing money. When you take out a loan, you agree to repay the principal amount (the amount you borrowed) plus the interest over a specific period. The type of interest rate (fixed or variable) and the rate itself have a direct impact on your loan balance. High interest rates can significantly increase the cost of your loan over time. Here’s a very simplistic comparison of how interest rates can affect your total loan balance:
- Higher interest rates loans: When interest rates are high, your monthly payments will include a more substantial interest component, and a smaller portion goes toward reducing the principal balance. This can result in a higher total loan balance over the life of the loan.
- Lower interest rates loans: Lower interest rates mean that a more substantial portion of your monthly payments goes toward reducing the principal balance. This can result in a lower total loan balance over time.
According to a Bankrate study published in October 2023, the average personal loan interest in the United States is 11.43%. It is worth noting that a plethora of factors impact your credit score, including income, debt-to-income ratio, employment status, loan terms, and more. Still, the following table should provide a bird’s eye view of average interest rates for different credit score brackets:
| Credit Score | Average interest rate |
|---|---|
| 720 – 850 | 10.73% – 12.50% |
| 690 – 719 | 13.50% – 15.50% |
| 630 – 689 | 17.80% – 19.90% |
| 300 – 629 | 28.50% – 32.00% |
*Source: Bankrate
2. Loan term
The duration of your loan can affect your total balance. Short-term loans generally have higher monthly payments but lower overall interest costs, while long-term loans offer lower monthly payments but can lead to higher overall interest expenses.
3. Missed or late payments
Failing to make timely payments can result in late fees and penalties. Moreover, it can lead to increased interest costs, as interest accrues on the outstanding balance.
4. Loan refinancing
While refinancing can lower your monthly payments, it may increase your total loan balance over the life of the loan. Understanding when and how to refinance is essential. If you don’t have a strong understanding of finance and how loans work, it’s advisable to consult a financial advisor for guidance.
5. Additional borrowing
Taking out more loans while still managing existing debt can lead to a snowball effect, increasing your overall financial burden. It can be an especially risky idea to take out a new loan to pay off an existing one.
6. Inflation and other economic factors
External economic factors, such as inflation, can affect your loan’s real value. It’s essential to consider these factors when managing your total loan balance over time. Like with interest rates, it’s essential to consider how inflation impacts fixed- and variable-interest loans:
- Impact on fixed-interest loans: If you have a fixed-interest rate loan, your monthly payments remain the same throughout the loan term. While this provides stability, it means that as inflation rises, the real cost of your loan decreases. In other words, the fixed payments you make will have less purchasing power in the future.
- Impact on variable-interest loans: Variable-interest rate loans, on the other hand, can be directly impacted by inflation. These loans typically have interest rates that are tied to a benchmark rate, such as the prime rate. As inflation rises, central banks may increase benchmark rates to combat it. When the benchmark rate rises, the interest on your variable-rate loan also increases, potentially making your loan more expensive.
The role of compounding interest
Compound interest is a crucial concept that can significantly impact your loan balance. It refers to interest calculated not only on the initial loan amount (principal) but also on the accumulated interest from previous periods. The longer you hold a loan, the more pronounced the effect of compounding interest.
Comparing compound interest (in blue) versus non-compounding interest (in red). The effect of compounding becomes more pronounced over time.
Whereas compounding interest can be very beneficial when accruing interest on an asset (like dividend stocks or cash deposits), the compounding effect of interest on a loan balance can have a very detrimental effect on building one’s wealth over time. For this reason, you should aim to reduce your total loan balance as quickly as possible, otherwise, you will pay a lot of interest on your loan.
However, it is important to note that inflation slowly erodes the value of money over long periods of time, meaning that paying a $1,000 monthly loan payment today is definitely not the same as paying $1,000 per month in 30 year’s time.
How to manage and reduce your total loan balance?
The following strategies can help you keep your total loan balance under control and prevent any unwanted increases:
- Early repayment: Making extra payments or repaying your loan earlier than the agreed-upon term can save you money on interest and reduce your total balance swiftly.
- Debt consolidation: Consolidating multiple loans into one can simplify your payments and potentially reduce interest rates. However, be cautious and do the math to ensure it genuinely lowers your total balance.
- Financial planning and budgeting: The importance of creating a budget and sticking to it cannot be overstated. A well-managed budget can help you stay on top of your loan payments and make informed financial decisions.
- Seeking professional financial advice: In complex financial situations, consulting with a financial advisor can provide invaluable guidance.
- Loan forgiveness programs: Certain loans, such as student loans, may offer forgiveness programs. We’ll explore when and how to take advantage of these programs.
The bottom line
Understanding what increases your total loan balance is essential for responsible financial management. By taking a balanced approach to borrowing, making informed decisions about interest rates, loan terms, and repayment strategies, you can take control of your financial future. Remember that responsible borrowing and effective debt management are key to financial success.
If you are looking for information about your loan balance, there’s a good chance that you might be considering buying a home or otherwise participating in the real estate market. To learn more about the topic, you can check out our housing market predictions and an analysis of the likelihood of the housing market crash.
Source: https://coincodex.com/article/33671/what-increases-your-total-loan-balance/