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" appears on credit card literature and loan
information everywhere. Many people believe it's a very
straightforward concept; however, this is often not the case.
What then is so complicated about interest rates, and how can it
affect the total cost of debt?
The answer will depend on the type of interest rate you have on
each of your debts. You say you didn't know there was more
than one type? Well, now you do, and it's about time you find out
what your lenders are actually charging you.
The first type of interest rate 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.
Because it is easy for people to understand, many borrowers
assume that this is the type of interest rate they are paying. That
may not be the case.
Next is the "periodic interest rate," which if used as in the
example above, charges you a percentage of that 10% interest
based on how quickly you pay off the loan. If you pay it off in one
month, you would pay 1/12 of 10% interest; in two months, it
would be 2/12 of 10%, etc...
A variable interest rate, as the name suggests, varies. The rate
of interest will rise and fall based on fluctuations of an
underlying interest rate index, for example, the prime rate. The
prime rate is the lowest interest rate banks charge to their
largest and best rated (most creditworthy) customers. Many
credit card companies charge a variable rate of interest.
Compound interest rates involve interest being charged on
interest. A better explanation is that compound interest charges
interest on both the original principal of the loan and the
accumulated unpaid interest. This is an ideal situation for an
investor, but not for a borrower. Compound interest rates are
also referred to as effective interest rates and Annual Percentage
Rate, or APR.
The APR includes any closing costs you may pay on a loan; so if
you take out a mortgage for $200,000 and your closing costs are
$10,000, you're actually borrowing $210,000. Efectively, the
higher the closing costs, the greater the interest rate becomes.
Before you get too excited over promises of low interest rates,
learn how the rate is calculated so you can determine the actual
cost of the debt. Get the bottom line before you sign on the
dotted one.
|
|