Enlightening Information About Interest Rates

If you’ve ever taken out a mortgage, borrowed to buy a car or used a credit card, you probably understand the basic concept of an interest rate. But do you know the different kinds? And do you fully comprehend how interest affects your overall finances? Simply stated, interest is the cost you pay to use credit. Typically, it is a percentage of the amount you’ve borrowed (the principal). How a lender calculates interest can greatly affect how much you ultimately pay for the item you’ve bought on credit, whether it’s a home, a car or a new outfit.

Here are a few terms you should know to better help you understand interest:

APR – Annual percentage rate (APR) is a single number that represents the actual yearly cost of a loan, including interest, fees or any other costs. It’s important to know the APR when you borrow money because it will give you a more realistic picture of how much a loan will actually cost you over its lifetime.

Introductory rate – You’ll often see this term associated with credit card offers. A card issuer may offer you a very low rate on purchases for a set period of time, after which the rate may – and often does – rise. The rate may increase sooner if you fail to meet provisions outlined in the introductory offer, such as paying late. The Fair Credit Reporting Act governs how credit card companies can make this type of offer and when they can raise your rate.

Prime interest rate – Your mortgage or credit card interest rate may be tied to the prime interest rate. This is a rate set by banks as a base for many types of loans. Many banks set their prime rate based on the federal funds rate, which is the interest banks charge each other for the short-term loans they need to meet federal regulatory obligations.

Adjustable rate – Some mortgages have adjustable rates, meaning the interest rate you pay on the loan at the beginning will rise at an agreed-upon time. Commonly, the new rate is based on the prime interest rate at the time the mortgage resets, plus an additional percentage over prime.

Compound interest – When you borrow money, you pay interest on the principal – the amount you actually borrowed – until your balance is paid. If you make a credit card purchase in January and pay it off in February, you’ll pay no interest at all. If you pay the balance in March, you’ll pay interest on the principal for both January and February. Compound interest means you’ll also pay interest in March on the unpaid interest you accrued in February, causing you to pay much more for a product than its initial cost as you continue paying interest toward the unpaid principal and unpaid interest.

Interest is an unavoidable cost of borrowing money. But by paying your bills on time and paying down debt quickly, you can minimize the amount of interest you pay – and maximize effects of wisely exercising your credit muscles.