There’s no doubt if you’ve bought a house or a car that you’ve encountered interest rates. The same thing goes for using a credit card. Yet most people have no idea how interest actually works.
We take a comprehensive look at how the interest rate affects your loan payments and other aspects of lending. Examples help you to understand how these principles apply in the real world.
While not a super technical deep dive, you should feel confident about responsibly accessing credit when necessary, including using credit cards without everything getting out of control.
An Interest in Interest
Everyone should know how interest works with loans. As they say, knowledge is power. By understanding exactly what interest does, you can better manage your finances. That means you won’t be wondering what’s happening with your money, but instead will have a good grasp on how to ensure you have enough to cover everything. It’s a less stressful and more productive way to live.
Too often people think of interest as a negative thing, so they don’t really think about it. The truth is interest isn’t necessarily something you can avoid. Sometimes you need credit for covering living expenses, like if you’re looking for a car loan in Hamilton. After all, how many people have enough money sitting in a savings account to pay for a new car? The same goes for a house and other especially expensive items.
Credit cards can help cover sudden, unexpected emergencies. You also might benefit from certain rewards if you use a credit card to pay for certain items. Not only that, by using credit cards, you’re actually building up a positive credit history.
Of course, you need to understand how interest works so you use credit responsibly. Failure to do so will lead to negative items on your credit report and more trouble, as you’re about to learn.
You’ll often see interest on a loan, whether it’s for a credit card, home loan, or a car loan in Hamilton listed as APR. This stands for the annual percentage rate or the yearly interest rate for the loan.
When you apply for credit and get an approval, pay careful attention to the APR. This number will help determine just how much you’ll be paying each month and for the life of the loan. You want the APR to be as low as possible since that will save you money.
When it comes to credit cards, you might find some creditors use DPR or the daily periodic rate. This is a way to calculate how much interest you owe after carrying a balance for a specific period.
DPR is actually simple to calculate, since it’s the APR divided by 365, or each day of the year.
The interest rate you get on a loan is in part a statement of how much the creditor, which often is a bank, sees you as a risk.
If a bank thinks you’re more likely to be late on some payments, the interest rate will increase some. When a lender believes you’re also a risk for missed payments or even defaulting on a loan, the interest rate balloons further.
How do lenders decide how risky you are for a loan? One of the main ways is by pulling your credit report. This is why it’s a good idea to know what’s on your credit report and to determine your scores. You won’t be caught off guard if you prepare in this way. Also, if there are incorrect items on your credit report which are hurting your score, you can dispute those items and hopefully have them removed.
When creditors pull your credit score as you’re shopping for something like a car loan for Hamilton, they pay attention to several details. One is how many lines of credit you have at the moment and how much you owe on each. They’ll want to know what your history of paying on loans is like, including collections or bankruptcies in the past. Inquiries on your credit report, which are generated when you apply for credit lines, are also something lenders watch.
You also fill out information about yourself when applying for credit. Lenders will ask for the name of your employer, how much you make, as well as big financial commitments like your monthly housing payment. This is used to calculate how much you can reasonably afford to borrow.
Another factor which affects interest rates is the type of loan. Certain types of credit are viewed as inherently riskier by lenders. Just like when they see a person receiving a loan as a greater risk, lenders will automatically charge more interest for these types of loans.
Secured loans, which involve collateral or something a lender can take if you stop paying, are a lower risk for banks. This would be something like a car loan in Hamilton. When a person doesn’t keep up on their payments, the bank sends a repo truck to take the car. If the borrower pays the amount they’re behind on, the car is returned. Otherwise it’s sold and the proceeds are used to cover a portion what’s owed on the entire loan.
Unsecured loans don’t involve any collateral. This would be something like a credit card, where you simply borrow money and pay it back, but without anything the creditor can take if you don’t make a payment.
Because secured loans are less risky for a lender, the interest rates on them tend to be lower. As you can guess, the interest rate on unsecured loans is normally higher since the loan is riskier for the lender.
National Interest Rate
Then there’s the national interest rate, which is set by Bank of Canada. This a benchmark rate, or something the rest of the finance industry in the country uses to set its own interest rates.
You have absolutely zero control over the rates Bank of Canada sets at any given time. That’s not a fun thing to think about, but the fact is that the interest rate you get on a loan is absolutely affected by this number.
The bank sets its interest rate based on a variety of economic factors for Canada. It’s a complicated process you don’t need to understand entirely, especially if you’re just looking for something like taking out a car loan in Hamilton. Just know this number will impact the interest rate you receive, no matter how good your credit score is.
Since they’re a different type of loan than what you get for a car loan in Hamilton, you need to understand how credit card interest rates work.
Some credit cards have what’s called a variable rate. That means the APR can change from one period of time to the next. Since you could have the same credit card for years on end, and factors affecting interest rates will shift during that time, it makes sense why the APR wouldn’t always be the same.
To calculate the monthly finance charge for a credit card, you need to know the APR and the DPR. In addition, figure the average daily balance for the billing cycle, plus the number of days in that cycle.
When you have a balance on a credit card, the interest is calculated on a daily basis. This means for each day you haven’t paid off the card, you owe more money. It’s all based on the DPR, which is why you should know that number.
The good news is most credit cards have what’s called a grace period. During that span of time, if you have a balance on the account and you pay it off by the end of the grace period, you don’t owe any interest. That’s great news if you don’t spend too much and can pay off your credit card at the end of each billing cycle. But, if you do carry a balance on that card, you end up paying interest on that amount for each day past the grace period that you still owe money.
Always read the fine print when signing up for a new credit card. Many have an annual fee or other fees you must pay. This will impact how you can use the card. Exactly when and how interest on the account is applied will also be spelled out in the cardmember agreement, so don’t neglect to actually read the details.
Fortunately, the car loans usually are a simple interest loan. This means the interest is only used on the principal amount you borrowed to buy the car. If you make principal-only payments on your car loan, you will actually end up paying less for the car over the term of the loan. That’s because the interest you’re paying will be lower since the principal has shrunk.
There are some car loans where a balloon payment is used. This means at the end of the loan term you must pay a large sum to zero out the principal amount of the loan. The interest is usually still applied to the full value of the principal.
Variable rate car loans also exist, although they’re not as common. Since the interest rate can decrease or increase during the loan term, what you pay each month can fluctuate. Usually there’s a cap to how much the interest rate can increase or decrease, keeping things a little more predictable.
Just like other loans, a home loan also comes with an APR. Included in this number is the interest rate as well as certain fees. Among those might be an origination fee and mortgage insurance. You have the option of paying those fees separately, or if you prefer, they can be rolled into your loan. This isn’t part of the interest rate, but these fees will absolutely impact how much you pay each month.
It’s become pretty common for people to take out longer and longer loans for purchases such as cars. That strategy helps reduce the monthly payment amount, but there’s another factor you might not be considering.
The long the length or term of the loan, the higher the interest rate. Lenders figure that if you’re paying a car loan back over the space of 72 versus 48 months, there’s a higher chance that something could go wrong for you financially before you can pay off the loan.
For this reason alone, it can sometimes be wise to go with a shorter loan term, even though the payment amount each month is higher.
The nice thing is interest rates can work for you and not always against you, even though by now it probably seems like the opposite is true. Certain bank accounts increase in quantity over time using a set interest rate. This normally is something you’ll see in savings accounts, but not always, because there are some checking accounts, plus other accounts like money market accounts which also use interest to your advantage.
If you get in the right situation, you might have the chance to save money and get paid by the bank as it temporarily uses those funds. That interest can accumulate to a significant amount over time, plus you’re not taking a risk that you might lose some cash in the process, unlike with investments such as the stock market.
Just beware that relying solely on bank interest might not be best. Sometimes the item you want to buy might be appreciating in value at a higher rate than the interest attached to your account. In that kind of situation you’re actually losing money.