Debt Is Expensive: Interest Rates Explained
Debt Is Expensive: Interest Rates Explained
If you’re in debt, that means you’ve borrowed money or have a line of credit, and that means you’re paying interest. The term “interest rate” is on all credit card literature and loan information everywhere you look. Most people assume it’s a straightforward process, which, unfortunately is usually not the case. What, exactly, does it mean and what effect does it have in the total cost of your debt?
The answer is going to vary depending upon the type of interest rate you have on each of your debts. Oh, you didn’t know there was more than one type? Well, now you do. It is important to educate yourself on what your lenders are charging you.
The most basic of all interest rates is the “simple interest rate” and it is exactly that, simple. If you borrow $1,000 at 10% interest, that means the total cost you will pay in interest for one year is $100. It is the easiest for consumers to understand, and it is what most of us think we have. Read on, as that belief is often not true.
Next, we have the “periodic interest rate,” which, if using the example above, charges you a percentage of that 10% interest based on when you pay it off in under a year. If you pay it off in one month, it would be 1/12 of 10%; in two months, it would be 2/12 of 10%. Make sense?
A “variable interest rate” is pretty much summed up by its name. This interest rate will rise and lower (vary) based on the changes of an underlying interest rate index; such as the prime rate, which is the interest rate banks charge to their best - i.e. most creditworthy - customers. Many credit card lenders use interest rates that are based on a variable interest principle.
“Compound interest rate” is, interestingly enough, interest on interest. Confusing, eh? A better explanation is that a compound interest rate computes interest on both the original principal of the loan AND the accumulated unpaid interest. Nice if you’re investing, not so nice if you’re borrowing. A rose by any other name still smells as sweet; and for this type of interest, it comes with two additional titles: Effective interest rate and, for the borrower, the almighty Annual Percentage Rate, otherwise known as the APR.
The APR includes any closing costs you may pay on a loan; so if you take out a mortgage for $100,000 and your closing costs are $5,000, you’re actually borrowing $105,000. What happens with the APR, however, is the greater the closing costs, the greater the interest rate. Specifically speaking, closing costs make your interest rate higher.
So, what does all this mean? Don’t be swayed by promises of a low interest rate - find out how that rate is calculated so you can determine the true cost of the debt. Get the bottom line before you sign on the dotted one.
