My finances, my projects, my life
August 5, 2020

Loans: the right approach to choosing one (2/3)

Many people may have loans, but you should never take one out lightly. In a series of three articles, myLIFE sets out the right approach to this topic. After demonstrating the right approach to take when you need a loan, or think you do, in this second article we discuss how to make the best choice.

In our first article on the right approach to take when you need a loan, or think you do, we reminded you that a loan not only costs money, but can also weigh heavily on your mind when you have to make a decision. We suggested that you ask yourself if the financing you want now is really to meet a future need. It is important to think in terms of needs instead of wants to get yourself out of the cycle of instant gratification. If you are here, it’s because you have decided that a loan is the right solution for financing your project. Excellent! Now, you have to decide which one.

Time to choose

Deciding to take out a loan is one thing, choosing the best kind is another. You need to take into account and understand all the terms and conditions associated with borrowing money. Many people only consider the monthly payments, without really understanding the total amount that they will pay back in the end.

Let’s take the example of a €500,000 loan at 2% interest. Paid back over 25 years, your monthly payments will be €2,119 and the total cost of paying back the loan will be €635,782, not including sundry charges. Paid back over 15 years, your monthly payments will be €3,218, but the total cost of paying back the loan will “only” be €579,158. That’s a difference of €55,000!

As you can see in this example, considering the total cost also requires you to take into account the term of the loan, the interest rate and whether it is fixed rate, variable or a mix of both.

According to the Central Bank of Luxembourg, 75% of mortgages taken out in the Grand Duchy are variable rate and have terms of 25–30 years. This does not necessarily mean that this kind of loan is the best choice for you. How can you tell?

Wading through the mass of available information

European law requires all credit institutions and agencies to provide their clients with detailed examples – often in the form of tables – that illustrate how the total cost of a loan is calculated.

Consumers can only compare a certain number of product characteristics at the same time. The risk is to focus on superficial characteristics.

Although this information is very useful, it does have a negative effect: as the information accumulates, more and more weight is added to the consumer’s mental load. However, behavioural studies have shown that consumers can only compare a certain number of product characteristics at the same time. In these circumstances, the risk is to focus on superficial characteristics like waived application fees. Even though application fees are clearly indicated in the marketing materials you receive, they are insignificant compared to the total cost of the loan. They should definitely not be the factor on which you base your decision.

As you wade through a large amount of information, your brain tends to focus on what stands out, for example a number in bold or bright colours. Be careful: just because this information is highlighted doesn’t mean that it’s the most pertinent to your individual situation. You should also learn to take a step back from loan calculators in the shape of number lines with sliders on commercial websites. The elements (the slider, the amount indicated and the suggested number of monthly payments) are set up to influence your decision using what’s called an anchoring effect. By “anchoring” your attention on predefined initial settings, these simulators can push you to make a decision that isn’t the best for you.

Inevitable compromises

When looking for the best loan for your situation, keep in mind that you will have to make compromises. Would you like to pay back your loan faster? The total cost will be lower, but your monthly payments will be higher. And this will have a direct effect on your current buying power. In some cases, it can even represent a liquidity risk. Giving up everything for 15 years to pay off a house isn’t necessarily ideal if you’re someone who loves travelling and going out with friends. To have the money you need for the life you want, make sure you have your priorities in order when making your budget and taking out a loan.

Even so, it’s not an easy decision. You can easily be influenced by the way in which information on the financial product is presented. Research conducted in Ireland by The Economic and Social Research Institute (ESRI) shows that consumers choose different loans depending on the order in which the information is presented.

So, when they are presented with the total cost of the loan before the monthly payments, they more often choose a shorter-term loan and end up paying less overall. Conversely, when monthly payments are shown first, they tend to choose a longer-term loan, and pay more overall.

This data shows how easily we can be influenced and how rarely we make fully informed decisions when looking for personal financing. In any case, there is no perfect product. You need to consider all of the possible permutations in type, term, total cost and monthly payments in order to choose the best loan for your current and future potential financial situation.

As we arrive at the end of this second article on how to take the right approach to loans, it seems like the right time to encourage you to use the objective viewpoint of an expert who can assist you in what is really a financial arbitration. Once you have made your decision, you can head to the third step: managing your loan repayments.