The act of borrowing money always comes with an interest rate. Whether it’s getting a mortgage, applying for a student loan, or participating in a small monetary transaction involving your credit card, interest rates are going to be attached. But, exactly what are interest rates?
While interest rates are a part of financial life and nothing to be afraid of, a proper understanding of how they are determined, and the negative consequences of mishandling them, can mean the difference between a healthy financial life and thousands of dollars in unmanageable debt.
What Are Interest Rates?
Banks, mortgage lenders, and other financial institutions receive payment for their lending services through interest rates. Remember, the act of borrowing money is never free. Most loans are given by businesses, not charities, and businesses require interest rates to make a profit and keep their doors open.
If you look at your credit card statement, you’ll notice the interest rate is determined by a percentage. This reflects what you would pay back to the financial institution in addition to the principal you originally borrowed over the course of a year. For example, if you borrow $10,000 to purchase a car with a 10 percent interest rate, you will ultimately pay an extra $1,000 over the course of a year in addition to what you borrowed.
Interest rates for different types of loans vary wildly. A typical credit card interest rate can be anywhere from 10 percent to 29 percent depending on your credit score. A “payday loan” (a short-term loan option offered by some agencies for emergencies) can come with rates as high as 400 percent. You can always check your monthly statements to track what interest rates you are currently paying.
Interest Is Recalculated Monthly
The amount of interest you will pay over the course of a year can be adjusted by budgeting correctly. If you borrow $1,000 at a 10 percent interest rate, you will pay an extra $100 annually over the course of that loan. However, if you make a $100 payment, then, the following month, the interest you pay will be recalculated to reflect how much you still owe. With a new $900 principal at a 10 percent interest rate, you will then pay an additional $90 annually instead of $100. While calculating this can be complex when compound interest is factored into the equation, it essentially boils down to this: the more you pay toward your principal each month, the less total interest you will pay. If you pay off your entire balance in the first month, you won’t pay any interest at all.
Interest Rate vs. APR
On the surface, the terms interest rate and APR (Annual Percentage Rate) sound similar, but there are some key differences between the two. APR is a way to illustrate how any upfront payments and fees associated with your transaction are spread out over the life of the loan. These types of fees can include broker fees, discount points, and closing costs associated with mortgages. Your base interest rate is also included in the APR, which is why it normally appears as a higher percentage than your interest rate. While both are important to monitor, APR will give you a more accurate depiction of how much you will ultimately pay, assuming all variables stay consistent.
Always Shop Around
If you are considering a loan, it is important to know what your options are. To do that, you must shop around. Do not accept the first loan you’re approved for. Different companies will offer you different interest rates to win your business. Many mortgage companies, for example, will offer to pay your lender fees and closing costs, resulting in drastically lower APRs compared to their competition. If you are seeking a $200,000 mortgage on a new home, special offers like these can result in thousands of dollars in savings over time.
Small steps like these are what separate the financial ninjas from the financial zombies. Use caution, have the patience to seek out what these businesses can offer you, and your diligence will pay off.