Guest Author: Ellie Pugh
These days, the average American has about $38,000 in personal debt. While debt is not necessarily always a bad thing, it does come with extra costs than can certainly add up over time — and this comes in the form of interest. Though this is usually expressed in small percentages, The Simple Dollar’s round-up of how much the average person pays per year is an eye-opener: $5,646 in mortgage interest, $855 in credit card interest, and $641 in student loan interest. To understand why and how we’re paying these amounts for borrowing money from a bank or lender, let’s take a closer look at the basics when it comes to interest rates.
Interest rates, put simply, signify the cost of borrowing money. When a bank allows you to borrow their money to cover the costs of a big purchase, they will charge you with a monthly installment, which is the sum of a percentage of the principal amount they loaned you and the interest. The interest is computed by applying the interest rate to the total unpaid amount. But how are these rates decided? In a post by FXCM on ‘How Central Banks Control Interest Rates’ it’s explained that central banks are tasked to influence interest rates because they have a profound effect on everything from job creation to economic growth. Here in the US, the Federal Reserve is tasked to set interest rates in a way that would provide maximum employment and stable inflation. Think about it — high interest rates mean no one would want to borrow money, and this could lead to a recession because consumers and businesses would spend less. In contrast, though, low interest rates mean that consumers and businesses can spend more as borrowing becomes cheaper, and this can result in inflation. The Federal Reserve controls interest rates to help strike a balance between the two. Determining interest doesn’t just end there, as the type of interest plays an important role as well. The types of interest are simple interest and compound interest. The former is a rate that’s based on the principal amount, while the latter compounds that by the interest accrued over time.
When you deposit your money in a bank, you are essentially loaning them your cash to be used for the bank’s transactions, like investments and loans to other consumers. Compound interest — the type of interest most banks use — allows you to earn interest not just on your deposit, but also from the interest a bank pays you. Since it’s in a bank’s best interest to have you store your savings with them, they pay you an interest rate for the money you’ve lent them. Acquiring this type of interest is done through either a high-interest savings account or a certificate of deposit. As we shared in ‘Opening Your First Bank Account: What You Need to Know‘, high interest rates are better for your bank account because they require the bank to pay you more money. This is where compound interest enters — as you put away your money in the bank over time, the money you have in the bank will continue to grow at a higher rate.
Of course, paying interest is a completely different procedure from earning it. Here’s how two of the most common payments are affected by interest rates: <strong>
Mortgage – When mortgage interest rates fell to historical lows, the number of mortgage applications surged by 30%. The quick rise in applications could be tied to the difficulty that comes with paying off a mortgage, as the hefty price tag calls for borrowing more money from the bank. However, most homeowners manage the interest rate by asking their bank for a fixed-rate mortgage, which means that your mortgage interest rate will not change during the period of your loan despite the market index.
Credit Card Debt – Unlike mortgage payments, credit card debt doesn’t usually last a lifetime. However, its interest rates can go higher much quicker, since you’re paying for the money a bank has lent you for your spending. For a mortgage or car loan, the bank can claim your house or car, respectively. But when it comes to credit cards, the money has already been spent on various purchases, which is why you need to make sure that your payments are on time. Moreover, you’ll want to avoid paying just the minimum amount, as this can cause higher interest down the road as well.