Few people have the cash to make major purchases without getting some type of loan, which is something that lending organizations are well aware of. That is why they have come up with a multitude of tempting incentives to draw people into borrowing thousands of dollars from them. However, they don’t do it for free. Each loan has a set fee added to it. That fee is the interest. There are two different types of interest rates to choose from. The first one is a fixed interest rate. The second one is a floating interest rate.
Floating interest rate loans are the most confusing to understand. This is because they conceal key information from borrowers. If you want to better understand floating interest rates, read this article. Following is a list of six of the most deceptive aspects about floating interest rates to look out for.
6 Facts You Should Know About the Floating Interest Rate
1. Higher Rates
The main reason that borrowers may want to choose a floating interest rate is that they think they will end up paying less interest in the long run. This is rarely the case. For the most part, floating interest rates are, on average, about 2% higher than fixed interest rates.
2. Deception of the Total Interest to be Paid
Fixed interest rates are simple for borrowers to understand. All they have to do is make payments of a set amount on a monthly basis towards the main loan amount. However, at the beginning of the loan, more money goes towards the interest than the main balance. This ensures that the lender collects as much money up front as possible.
When a floating rate is attached to a loan, borrowers have no idea what to expect regarding the total interest that they will pay over the life of the loan. This is because the amortization schedule will be constantly changing. This gives lending institutions a lot of leeway to deceptively charge more interest than they normally could.
3. Confusing Mixed Rates
Borrowers have to carefully read the contracts regarding the interest rates attached to their loans. This is because sometimes a fixed interest rate switches to a floating interest rate after a certain amount of payments have been made. Also, lending institutions are not always so quick to send out a new amortization schedule to reflect this information to a borrower.
Sometimes, this can go in a borrower’s favor though. For example, if a loan contract states that a borrower can change to a floating interest rate at a later date, it could save them money if the new rate is less than their original fixed interest rate was. But this isn’t always the case. More often than not, lending institutions charge a fee of up to 5% or more of the original loan amount for making the switch. So it isn’t actually saving any money in the long run.
4. Variable Cause and Effect Issues
The amount of a floating interest rate is supposed to be set by a base rate that is given by a main reserve bank. Each country has their own separate reserve bank and information to follow though. All the reserve banks are influenced by outside factors, such as inflation and how well the economy is doing.
This works well because it gives a guideline that a borrower can look up to make sure that they are paying a floating interest rate that is reasonable. However, if a country suddenly experiences turmoil that could affect the economy, then the rate could suddenly skyrocket.
5. Negative Amortization Costs
Some lending institutions that offer floating interest rates use a practice called negative amortization. This means that they can get a borrow into a lot of hot water if they don’t understand it. Negative amortization means that the monthly payments that a person makes don’t change throughout the life of the loan. But each month’s payment is based on whatever the new interest rate is. That means, if the interest rate happens to increase to an amount that is higher than the payment was, there is an unpaid balance remaining on the borrower’s loan. So, if they don’t know to send extra money to cover it, they can quickly default on the loan.
Reputable lenders will often tack on the uncovered balance to the end of the loan, which prevents this from happening. But it still increases the total amount that is owed.
6. Balloon Payments
Most borrowers understand that the last payment of a loan won’t be the exact same amount that they have been paying all along. But if an amortization schedule is correct, it shouldn’t vary by more than a few dollars. So it is quite shocking to get a notice from a lending institution that says that you owe a much larger sum. Then, if you don’t pay it, the loan will be in default.
This type of lending practice is a balloon payment. Borrowers should receive notifications about its occurrence before they agree to the loan. But if they don’t understand how large it could possibly be, or the way that a floating interest rate could affect it, they could end up struggling to find a way to pay it.
In conclusion, there are six different deceptive aspects about a loan that a floating interest rate can hide. So those who are considering this type of interest rate for their next loan should be sure to carefully read their loan contract. This way, they will avoid accidentally agreeing to any deceptive lending practices. Banks and other established financial institutions are less likely to employ these practices than smaller lending companies that focus on short-term loans are though. So it is best to stick to getting loans through them whenever possible.
Those who already have a loan with a floating interest rate may want to review their contract. This is to be sure that they won’t have any hidden fees or extra payments later on too.
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