There are three common ways to repay your loans: annuity loan, lump sum loan, and short term loan. The terms are very similar and the repayment terms seem to be the same at a glance, which makes it very easy to mix loans.
Therefore, we will now go over the definitions of the terms, with the help of examples. We start by telling you about an annuity loan, which often comes with mortgages.
In an annuity loan, the loan is repaid in equal installments, which include both the principal repayment and interest charges. If the reference interest rate of the loan changes during the loan period, the amount of the installment will also change. However, the term of the loan remains unchanged on the annuity loan. The term annuity refers to an annual installment, but annuity loans can also be repaid monthly, for example.
For example, if the interest rate reference is for a loan is 12-month Euribor, the interest rate will be adjusted once a year. If the reference rate changes, the annuity loan will be repaid new installments for the remaining term of the loan. In addition to the principal, the new installment comprises interest charges for the remaining period of the loan.
At the beginning of the loan period, the loan amount is at its highest, which is why interest expenses are also the highest. As a result, the monthly installment initially consists largely of interest expenses. At the end of the loan period, the interest rate is relatively low and repayment will accelerate towards the end.
If the interest rate changes, the amount payable will change
In an annuity loan, the amount that you leave your account with is always the same, but the current loan repayment rate is lower at first, as the interest paid is relatively high at the outset. If interest rates rise, the monthly installment will also rise. However, in an annuity loan, the amount leaving the account is always the same when the reference interest rate stays the same. Therefore, as the reference rate changes, the installment changes as well.
Fixed installment loan
As the name implies, the fixed lump sum loan is always repaid in equal installments regardless of changes in the reference rate. If the reference rate changes, the loan period changes. The installments thus include interest expenses.
If the interest rate changes, the loan period changes.
A fixed installment loan is a variation of an annuity loan. Here, the change in interest rates is reflected in the change in the duration of the loan and not in the rise or fall of monthly installments.
In a repayment loan, the loan amount is repaid in equal installments, but the amount of the payment always varies with the interest rate. The difference with annuity loans is that the interest is always recalculated on the outstanding loan capital. The amount of the installment will thus vary with each installment, even if the reference rate remains the same.
Unlike an annuity loan, the amount of money that comes out of your account in a flat-rate loan is always the same for each installment. If interest rates rise, the monthly installment will also rise.
Which repayment method is most profitable?
Annuity is often not the most affordable way of paying off a loan, because at the beginning of the repayment, most of the installment is just interest payments, and the loan is almost non-repayable.
An annuity loan will thus be more expensive than a flat-rate loan, where interest payments will decrease after each loan installment. In an annuity loan, the interest rate remains the same for each installment, since the interest cost is calculated on the full amount of the loan at the very beginning of the loan period.
In the case of consumer loans, the reference interest rate is fixed and is exactly the same as the one used for repayment. The installments are the same throughout the loan repayment period and the interest rate decreases as the main loan decreases.
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What if there are multiple loans?
If you have many loans open at the same time, it is best to pay off the highest interest rate loan first. Changing your payment plan doesn’t take much time, and with smart planning you can save a long penny. Many are mistaken that the loan agreement once agreed with the lender is written in stone.
In reality, banks and finance companies are often ready to negotiate changes to their payment program. For example, a bank may agree to reduce the amount of a low-interest loan for a few months so that the highest-interest debt can be paid off first.
It is worth remembering that all loans also have to pay account management costs and fees. Of course, these costs multiply as loans increase. In such a situation, it may be wise to combine smaller loans into a large loan, ie to pay off small debts with a new loan.
Combining loans is economically viable if the cost of a new loan is lower than the cost of smaller loans combined. Combining makes it easier anyway as there is only one loan amount to manage. Many providers offer loan consolidation services, including Bank Norwegian.
Early repayment of the loan
Most people pay off their debt in monthly equal installments. Sometimes, however, there may be a situation where it is possible to pay off the loan more, which in turn can make early repayment a topical issue.
Prepaying the loan is a legal right of the customer, so the loan can be repaid before its due date, even if not stated in the loan terms, the FCA outlines. Payment of larger installments than agreed is also allowed. Nonetheless, whenever you depart from the payment schedule agreed with your bank, it is a good idea to read carefully the terms and conditions of your loan. If necessary, you should also consult your bank to avoid any unpleasant surprises. In fact, the bank may calculate prepayments as advance payments or as additional installments.
Be careful when paying off your loan in advance, as there are three ways in which to lend can process extra payments:
In the prepayment, the excess installment is not directed against the principal, but the amount exceeding the initial monthly installment will only reduce future payments. This means that the repayment has no effect on the loan period. The original payment plan will thus remain unchanged.
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The idea of a prepayment is to pay off your future bills in advance – for example, you don’t have to pay off your loan for the next three months. After that, payments will come back as normal.
Prepayment is profitable if you want to pay off your upcoming summer vacation loans in advance so that you have more money available for your free time. However, the total cost of the loan and the term of the loan remain the same.
- Extra abbreviation
An additional repayment is a single amount that decreases the amount of debt, ie the principal of the loan. This repayment is profitable if a single larger amount is available. As the total loan amount decreases, so does the interest rate charged on it. The monthly payments will remain the same, but the total loan period will shorten. An extra repayment will thus reduce the total cost of the loan.
- Increasing the repayment amount
If your solvency improves during the loan period and you want to pay off your debt faster, you may want to agree with your bank or finance company to increase your monthly repayment amount.
As a result, debt will be reduced more rapidly, which will reduce the repayment time and reduce the total cost of the loan. It is a good idea to determine in advance whether the lender will charge a service fee for changing the repayment amount.