How to compute the real cost of a loan

Let’s face it, getting a loan can be quite difficult. What could be even more difficult is paying it off. Many borrowers apply for a loan without really taking the time to study the small details that could make a loan quite tricky. For example, paying off a loan is seen as just paying the principal plus the interest rate but one should really study how to compute for the real cost of a loan.

As a borrower you must keep in mind that you pay off the loan in stages – usually divided into equated monthly installments or EMI for the duration of the loan period. You should also remember that the EMI you pay today will have a higher present value when compared to the EMI you will pay ten years down the road. In order to correctly determine the cost of a loan, you must look at the present value of the group of EMI payments compared to the value of the loan amount at present.

The discount rate that approximates the two values will be the internal rate of return. This is what the lender makes on the loan awarded to you. In other words, computing for the IRR will give you the real cost of the loan.