A brand new, shiny credit card or a fabulous loan to get a new car all come with a dark side: interest. Creditors, credit card companies, and lenders all want to make money by approving a line of credit, and they gain that money through the use of interest that the consumer agrees to pay. However, even though interest rates can seem low, they can definitely accumulate over time and bury the average consumer in a mountain of debt.
In short, interest rates are the extra charge of money for borrowing money from another source, whether it’s a bank or a private lender. Interest rates vary depending on the credit account, loan, and creditworthiness of the borrower.
The most common term when it comes to interest is Annual Percentage Rate (APR). This type of interest is yearly interest that is produced by the borrower’s initial loan amount. This can represent several different things that are included in the loan, but the short of it is that APR is an annual rate of interest that the borrower must pay alongside the initial loan amount. Keep in mind that APR is compounded yearly, so the interest itself will grow the longer the loan terms are in effect.
For example, Ruth decides to buy a car from a dealership for $10,000. To make things simple, Ruth gets a loan for $10,000 without any down payment. The lender decides to set the APR at 5%. Ruth has two options in term lengths: 3 years or 7 years.
If Ruth decides to pay back the loan in 3 years, it would break down like this:
Initial Financed Amount: $10,000
Monthly Payment: $299.71
Total Interest (over 3 years):$789.52
Total Payments: $10,789.52
If Ruth decides to pay back the loan in 7 years:
Initial Financed Amount: $10,000
Monthly Payment: $141.34
Total Interest (over 7 years): $1,872.48
Total Payments: $11,872.48
Even though the shorter term length requires a higher monthly payment, in the end, Ruth ends up paying less in interest. Interest accumulation is a long-term game of money, where the longer the game is played, the more money is required to finish it.
Keep in mind that the majority of interest these days is a form of compound interest. The other type of interest is simple interest, but not many lenders use this form of interest. Compound interest is essentially the compounding of the principal amount in addition to the interest that accumulated over a year; thus, the rate compounds on the new, larger principal. This essentially applies to every car loan, home mortgage, or credit card on the market at the moment. This is why interest can begin to overwhelm people over a longer period of time.
The national average of interest for a revolving credit account has been reported to be 15% in 2021 in the United States. This means that if the longer a balance persists on a credit card, the more interest the consumer will end up paying.
Let’s take the same example from above: Ruth decides to put a $10,000 punch into her credit card balance. The credit card has an APR of 15%. Ruth decides to only pay the minimum amount. The monthly minimum payment may vary between credit cards and the balance on the credit card versus the credit limit of the card. With this information, Ruth’s payments will look like this:
Initial Balance: $10,000
Monthly Payment: $200
Total Interest (over 78 months): $5,527
Total Payments: $15,527
By paying the minimum, Ruth ends up paying nearly a third of her overall balance in interest alone. However, if Ruth decides to pay more a month, the interest will be much lower.
Initial Balance: $10,000
Monthly Payment: $400
Total Interest (over 30 months): $1,900
Total Payments: $11,900
By doubling payment amounts, Ruth is able to save $3,627 in interest over the course of paying off her debt.
Interest rates vary depending on the type of credit the borrower decides to take: a credit card, car loan, personal loan, or home mortgage loan. The main thing that connects these things is that the lender or creditor will do a credit check on the borrower. Depending on the credit score and history of the borrower, the company will choose an interest rate: a better (lower) rate if the borrower is deemed trustworthy with their finances or a worse (higher) rate if the borrower is seen as untrustworthy.
In general, a higher credit score means a better loan or line of credit with lower interest rates. So it’s a good idea to have a favorable credit history before applying for a new type of credit, whether it’s a new revolving account or installment account. If you are in need of help improving your credit score and removing derogatory information from your credit history, then contact us at Fix Your Credit Consulting. Call us at (877) 212-2450 for a free consultation.
If you have any questions, feel free to give us a call at 877-212-2450!
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