We are used to lenders charging interest, but some lenders also charge an arrangement fee. In this blog we will explain why lenders use arrangement fees, how they work, and how to compare loans with and without them.
Don’t lenders make their money from interest?
The simple answer to this question is yes, but there are two reasons why they might use arrangement fees as well. The first situation is where a loan is small in value and/or for a short period of time.
The first thing to remember is that it can be costly for lenders to provide and administer loans. They have to pay for staff, rent, custom built computer software, credit checks, other business expenses, regulatory fees and they need to make a profit.
If you took out a $10,000 loan for 10 years with an annual interest rate of 10% you would make monthly repayments of about £130. Over the ten years you would pay the bank nearly £16,000. This is more than enough to cover the original amount borrowed, the risk that you don’t pay the loan payback and the cost of providing the loan.
But if you could afford repayments of £900 you could pay the loan back in 1 year. If you did this, you would only pay back £10,550. In this situation the bank has only made £550 on top of what they leant you. This would cover the risk of you not paying the loan back but would not leave much money for the cost of the lender providing the loan.
In the same way that if you borrowed £1,000 for 5 year at10% interest you would make monthly repayments of £21. After 5 years you would have paid the lender £1,300. Like a short time frame loan, the amount of money the lender makes would not cover the cost of providing the loan.
The arrangement fee helps to cover the cost of providing the loan.
What about mortgage arrangement fees?
This is the second situation you often see arrangement fees, but mortgages are usually for high values and long time periods, so the fee isn’t just to cover the arrangement cost.
In the case of mortgages, lenders often offer two types of products: those with arrangement fees and those without them. The two products will be for the same duration and the same value, but there is one key difference: the one with an arrangement fee will have a lower interest rate. The lender is using the fee to make money from you now, to make up for the reduced payment you will make in the future.
When do you pay arrangement fees?
If you need to borrow money now, it seems crazy that you would pay money to receive the money. because of this there are often two ways you can pay the arrangement fee: pay in advance or added to the loan.
Most people take out a mortgage to buy their house, but they may have enough savings to pay the arrangement fee in advance. By paying the arrangement fee in advance they are not paying interest on the fee, saving them money.
But someone taking out a payday loan, wont have the money to pay the arrangement fee and so must add it to the loan. this means they pay interest on the arrangement fee, making it more expensive.
How do I compare loans with arrangement fees?
When lenders calculate the APR of a loan, they must take into account any arrangement fees. This means if there are two loans with different interest rates and arrangement fees you can simply look at the APR to decide which one is cheaper over the life of the loan.
