Interest is what you pay to borrow money using a loan, credit card, or line of credit. It is calculated at either a fixed or variable rate that's expressed as a percentage of the amount you borrow, pegged to a specific time period. Understanding the definition is one thing, but applying it to your debt planning is another. Here are a few know-hows to aid you in the process:
APR and EAR: One effective way of making valid comparisons between competing loans is to check the APR (annual percentage rate) of the loan. All other things being equal, you'll want the lowest possible APR you can get. APR is the annual rate of interest without taking into account the compounding of interest within that year.
By compounding APR daily or monthly instead of annually, you get the effective annual rate (EAR), the interest rate you are actually paying. The general conversion factor for APR to EAR is EAR=((1+APR/n)^n)-1, where n represents the number of compounding periods of the APR per EAR period.
Be careful when you see an advertisement about a loan with a seemingly low interest rate. Although the quoted rates, which are usually the APR, appear low, you could end up paying more for a loan than you originally anticipated. Depending on how the rate is compounded, whether it is semi-annually, quarterly, monthly or daily, you will actually pay quite different rates with the same APR. The following table will give you some idea about how it works.
APR
EAR (What you are actually paying)
Semi-Annual
Quarterly
Monthly
Daily
5%
5.06%
5.09%
5.12%
5.13%
10%
10.25%
10.38%
10.47%
10.52%
15%
15.56%
15.87%
16.08%
16.18%
Why a low interest rate matters. Securing a low interest rate on a loan is important because it will dictate how much you have to pay monthly and how much you will need to pay in finance fees over the life of the loan. A high rate might mean you are paying more in interest for what you buy than you are on the actual purchase price. The longer your repayment period is, the more interest you will accumulate. Since the interest rate is compounding in most cases, over time, the accrued interest you'll have to pay on the loan can represent even more than the original amount you borrowed.
Common factors affecting your interest rates:
No matter whether you are having a debt from mortgage, credit card, auto loan, student loan, or any other loans, there are several common factors that can affect your debt interest rates.
Credit history and credit score. A good credit score and good credit history means that lending to you contains less risk, which can be covered with a lower interest rate. A bad score may mean you won't qualify for the loan, or if you do, you will likely be offered a higher interest rate. For example, lenders are now looking for credit scores of 720 or higher in order to provide the best interest rates on a mortgage loan. If you credit score is lacking or you have a history of late payments, you may not only get a high interest rate, you may be denied a mortgage loan.
Down payment. The more money you pay down- in other words, immediately- the less you have to borrow, and the lower your interest rate is.
Length of the loan. Shorter loan length will probably earn you a lower interest rate. For example, for mortgage, if you opt to take a 20 year mortgage versus a 30 year mortgage, your lender may be able to provide a better interest rate. Similarly, the lower the number of months for the auto loan, the lower the interest rates.
Type of interest rate. Interest rates can be either fixed or flexible. Fixed rate of interest is suitable for those who want to play it safe and flexible rates of interest is the type of loan interest that changes based on the changes in the market. Thus, it would be suitable for those who are bold enough to undertake risk.
Borrower’s income. Your lender will verify your income and calculate the amount of loan you can afford to pay based on your other financial obligations. A lowered-interest rate may be possible if the ratio between your debts and income is low and you can prove you can afford monthly payments.
Factors for interest rates on specific kinds of debt
Credit card. Credit card interest rates vary widely. Typical credit cards have interest rates between 7% and 36% in the U.S., depending largely upon the bank's risk evaluation methods and the borrower's credit history. Your credit card interest rate may be affected by where you go. If you get a card from a credit union you might only pay 9 or 10 percent. If you go to a bank you might pay 15 percent while a credit card company might charge you 20 percent or more for the right to borrow their money.
It will also affected by your credit limit. Your interest rate will be affected by the amount of money that you are allowed as your credit limit. A 10,000 dollar credit limit is usually going to have a lower interest rate as opposed to someone having a 500 dollar credit limit.
Other factors which may affect your interest rates include your employment history, repayment history and debt to income ratio.
You should know that credit card interest rates are the key to manage your debt. A good credit history is the key to lower your interest rate. So always ask yourself, have you ever paid late or gone over the limit on this card? Your interest rates are sure to be increased if they happen to find that you're a late payer. Most companies are lenient in imposing credit rates to its clients. They will low your interest rates if they find you a prompt payer in paying the minimum each month.
Auto Loan. The term of your auto loan is usually 36 months, 48 months, 60 months or 72 months. The interest rates between them fluctuate between 6.5 percent and 14 percent or even higher. A used car loan carries a slightly higher interest rate than for a new car. The interest rate also depends upon the cost of the car. An expensive car will carry higher interest rates.
Student loan. Federal loans generally come with lower interest rates than those available through banks or credit unions, due to government subsidies. College loan interest rates vary, and they fluctuate with the economy. But subsidized federal loans can come with interest rates several percentage points lower than those offered by private lenders.
In conclusion, to obtain a low interest rate you need to have a good credit score, borrow less money in conjunction with a 20% or greater down payment, get a shorter loan period, and provide proof of income. Since there are many options available, it is better to make a thorough research of the lender and the interest rate before applying for a loan and the best place would be nothing but online which is a good source of information and it saves a lot of time and money and offers a wide variety of comparisons. If you have the time, shop around by calling or visiting your local lenders. Ask if they have flexible payment terms, discounts, or extra perks.
Appendix: Average rate of different kinds of loans. (As of 07/15/2010)
Credit card. 