Four important questions to ask before signing a loan

Before taking on loans to pay for an education or a house, it's important to ask some key questions.

You're ready to apply for that big loan, whether it's a mortgage for a new house, student loans to pay for your college education, or a way to finance your first new car. But the debt you take on will be with you for years in the form of regular monthly payments. How can you be certain that you're ready for this financial commitment?

Financial experts say it's normal to be nervous before taking on a new loan, no matter what it's for. Still, you can ease some anxiety by asking the right questions before taking on your new responsibility. What you learn might surprise you — and help you decide whether that loan is really what you need. 

1. How Much Do I Really Need to Borrow?

Before applying for any new loan, determine how much you really need to spend. Many times, lenders might offer you the option to take out a larger loan than you actually need. If you're taking out a mortgage, for instance, you might be able to take out a loan for more than what the home is worth, and then use the extra dollars to pay for improvements to the property. 

But Andrew Josuweit, chief executive officer of Student Loan Hero, warns borrowers to only take out loans for what they really need.

"It can be tempting to take on a larger loan than necessary and have some extra play money," Josuweit said. "But that extra play money will end up costing you down the line. The larger the loan, the more interest you will pay. Only borrow what you need to avoid paying thousands of dollars in additional interest charges."

2. Can I Afford My Monthly Payment?

This is the most important question of all: Can you afford to make your monthly payments after taking out a loan? If not, whatever you are borrowing money for will seem like a burden, not a pleasure.

A rule of thumb for determining whether a monthly loan payment is in your budget is to calculate your gross monthly income — your income before taxes are taken out — and your total monthly housing expenses, including whatever your new loan payment will be. You'll want your housing expenses to total 36% or less of your gross monthly income.

3. How Much Will My Loan Cost Me on Closing Day?

It's also important to determine whether you can afford the closing costs associated with your actual loan. Some loans come with high upfront fees. David Hosterman, branch manager with Castle & Cook Mortgage in Greenwood Village, Colorado, says this is especially true with a mortgage loan. Closing costs for such loans — everything from property taxes to underwriting fees — can run thousands of dollars. Can you come up with the money to pay for these, or will you have to roll these costs into your loan, increasing your monthly payment?

"Such items as taxes, insurance, and mortgage insurance can have a major impact on a customer's payment," Hosterman said. "Customers need to make sure these items are explained to them and that the information is provided to them so they can have a clear picture as to what the total payment on the loan would be."

4. How Much Does This Loan Cost Each Year?

When shopping for loans, consumers too often focus on only the interest rate. This number is important, of course, but what's even more important is something called the annual percentage rate, or APR.

This figure tells you how much your loan will cost — including fees — over the course of one year, and is a more accurate measure of how much you're really spending on your loan.

"APR is the holy grail of loan cost," said Priyanka Prakash, finance specialist at FitBiz Loans. "You should never commit to a loan without knowing the APR."

Anthony VanDyke, president of ALV Mortgage in Salt Lake City, gives a good example of how important APR is. Say you are taking out a 60-month auto loan for $10,000 and are offered either a loan with an interest rate of 5% and $500 in upfront fees, or one with an interest rate of 7% and no fees. Which loan is better?

This isn't easy to discover without knowing the APR. But if you do know the APR, you'll know that the second loan, despite its higher interest rate, is actually cheaper over its lifespan. The first loan choice comes with an APR of 7.124%, while the second loan comes with an APR of just 7%.

"The loan with the highest interest rate is actually the cheapest loan option, but most people see the lower interest rate and unwisely choose option A," VanDyke said.

This article first appeared at Wise Bread.