In-ter-est rate – “The amount charged, expressed as a percentage of principal, by a lender to a borrower for the use of assets.” Basically, interest is the “extra” you owe to a lender for the privilege of using their money to buy something for yourself. The rate is the percentage charged to calculate the extra cost. How this all breaks down is that if you want to buy something and don’t have the money, you will owe “extra” to the person or institution that you borrow from to make your purchase. In your financial plan this means you are no longer budgeting to purchase something at its true cost, you now have to account for the extra money you will pay to own that asset now. The interest rate will determine how much extra and it is important to understand how interest rates affect your ability to borrow and pay back the funds.
An interest rate is usually determined by the amount of risk the lender is taking on by lending the money. If the lender gets an asset in return for the loan, it is called collateral. The most common form of collateral is a house or car title. Collateralized loans come with lower interest rates because the lender has the right to take the asset away if payment is not made. This is why car loans and home mortgage interest rates are lower than credit card interest rates, which usually don’t have collateral attached.
The interest rate is the amount charged by the lender to the borrower for using the assets. Plainly put, it is the price you pay to borrow someone else’s money. These rates are typically explained using the annual percentage rate (APR). This is a percentage number that determines the yearly cost of the loan or lease, and includes any other costs that are included in the contract. Different lenders will have different APRs, so it is important to decide what is best for you. By law, lenders have to disclose the APR before you sign any contract. It is VERY IMPORTANT to read and understand the interest rate at which you are borrowing; there can be hidden costs beyond the simple interest rate charged. For example, one lender could have a 10% interest rate, but a 14% APR. This would mean the charges and fees would equal 4% on top of the 10% interest rate charge. A different lender could have an 11% interest rate, but still a 14% APR, making their fees cost 3% of interest.
The APR determines how much you will be paying each year that you have the loan or lease. The rate is only charged on the amount of outstanding loan balance. There is another kind of interest rate called a flat interest rate, which is often used by car dealers trying to make a car loan sound cheaper. With this type of interest rate, the lender charges on the original amount that was borrowed, and not the outstanding loan amount. So you are always paying interest on the original, larger sum.
Financial engineering has produced many different forms of loans, rates, and payback schedules. Loans are not regulated nearly as much as the securities industry so there is significant room for lenders to develop their own terms. This means you, the consumer, must be extra cautious and diligent in understanding the terms of a loan including interest rate, fees, payback schedules, and collateral obligations. The cost of borrowing can significantly affect your monthly income, your financial plan, and your standard of living. A single percentage point increase on a $30,000 5% year loan costs an additional $800 over the loan. What could you do with an extra $800?
Jonathon Rowles Captain, USMC (Ret.)
Disclaimer: (have to do it) – This blog should not be considered financial, investment, legal or tax advice. Consult your licensed financial professional, tax advisor or legal counsel. This blog is for educational purposes only.