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The most basic measurement of a loan's cost is the loan's interest rate. When a lender loans out money, he will generally charge the borrower a rate of interest, which is calculated as a percentage of the principal. The rate of interest, as well as well the interest is compound or simple, will determine how much the borrower is required to pay to the lender over the full life of the loan.
In addition to a rate of interest, a lender will often charge the borrower a number of fees to compensate him for the costs involved in transacting the loan. For example, a mortgage lender will usually charge a variety of fees, including an appraisal fee and a service fee, to the individual taking out the mortgage. These fees are usually paid up front and do not incur a rate of interest, although occasionally they are lumped into the principal.
To calculate the appropriate rate of interest on
the loan, a lender will often attempt to assess the probability that the borrower is going to pay the loan back. This can be done by looking at the borrower's credit history. The greater the risk, the higher rate of interest a lender will charge. Similarly, a borrower may wish to assess any risk that the lender will not fulfill his obligations. If he suspects the lender will violate the terms of the deal, he may request a lower rate of interest to offset this risk.
When lending out money, the lender must also consider the source of money he will use to finance the transactions. While some lenders have cash reserves sufficient to lend the money, others will need to take out out their own loan to finance the deal. To make the loan profitable, the lender will need to find a source of financing that costs him less to secure than he will receive from the borrower. Possible sources of this financing include banks, investors and finance companies.