When you compare personal loans, the interest rate usually gets top billing. But many lenders also charge an origination fee, and it can change the real cost of a loan more than a point or two of interest. Understanding how this fee works is the key to comparing offers fairly and avoiding a loan that looks cheap but isn't.
What an origination fee is
An origination fee is a one-time charge for processing your loan. For personal loans it commonly ranges from about 1% to 10% of the amount borrowed, and some lenders charge none at all. The fee usually depends on your credit score, income and debt load, so two people can see very different fees from the same lender.
Some lenders add the fee on top of your loan instead, so you receive the full amount but borrow more. Either way you pay it, and you also pay interest on it over the life of the loan. Read the loan agreement or the lender's disclosure to see which method applies.
Most lenders take the fee out of your loan before you receive the money. If you are approved for $10,000 with a 5% fee, about $9,500 lands in your bank account, but you still repay the full $10,000 plus interest. That detail matters if you need a specific amount, such as the exact payoff on a credit card balance or a contractor's invoice.
Why APR tells the fuller story
The interest rate shows the cost of borrowing on its own. The annual percentage rate, or APR, folds in the origination fee, so it reflects what you really pay each year. Under the federal Truth in Lending Act, lenders must disclose the APR before you sign. When you compare offers with the same term, the APR is the better yardstick.
APR has limits. It assumes you keep the loan for its full term, and it does not show late fees or prepayment penalties. Comparing APRs is also only fair between loans with the same length, since a fee spread over five years looks smaller than the same fee spread over two.
A side-by-side example
Imagine two three-year offers for $10,000. Loan A has an 11% interest rate and a 5% origination fee. Loan B has a 13% rate and no fee. Loan A's monthly payment is about $327, and you repay about $11,786 in total. Loan B's payment is about $337, and you repay about $12,130. At first glance Loan A looks cheaper.
But with Loan A you only received $9,500. Your true cost of borrowing is about $2,286, compared with about $2,130 for Loan B, and Loan A's APR works out to roughly 14.6% against Loan B's 13%. If you need the full $10,000 in hand with Loan A, you would have to borrow about $10,526, which raises the payment to about $345 a month.
When a fee can still make sense
A loan with a fee is not always the worse choice. If the fee buys a much lower rate and you plan to keep the loan for its full term, the savings on interest can outweigh the upfront cost. If you expect to pay the loan off early, the opposite is true, because you pay the whole fee up front but save less interest. Also check for prepayment penalties, which some lenders charge in addition to the fee.
How to compare offers
Start by prequalifying with several lenders, including your bank or credit union and a few online lenders. Prequalification usually uses a soft credit check, which does not affect your score. For each offer, write down the amount you will receive, the APR, the monthly payment, the total of all payments and any prepayment rules. Then choose the loan with the lowest total cost that still gives you the cash you need at a payment you can afford.
Finally, ask whether the fee is negotiable or whether a co-applicant, autopay or a shorter term would lower it. A small change can save hundreds of dollars. If you'd like a second set of eyes, send your offers to a Next Money Source loan specialist and we will lay out the true cost of each one before you sign.
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