UNDERSTANDING HOW INTEREST RATES WORK
Depending on the kind of debt you have, the interest rate may be calculated differently. And unfortunately, lots of credit cards, for example, have provisions that allow the lender to raise your interest rate if your payment is late.
Here are some terms you need to know and understand with regard to interest rates.
APR. This stands for the annual percentage rate. It is the same thing as the interest rate charged when you borrow.
Prime rate:This is the rate the nation's largest banks will give their best customers for loans. Lenders use the prime rate as a base for setting the interest rates they charge the general public for credit cards and other loans. Your interest rate might be "prime plus 9 percent" (For example, in January 2005, the prime rate was 7.25 percent. A card that`s prime plus 9 would have an interest rate of 16.25 percent.) Most lenders use the prime rate as calculated by Tbe Wall Street Journal. This rate can stay the same for years, or it can change several times a year.
Fixed rate: or fixed APR: This is an interest rate that will generally not change.
Variable rate or variable APR: This rate will change. It's calculated on the basis of certain economic indicators, including the prime rate. When the indicators go up or down, so does the interest rate you pay.
Penalty rate: lf you're late on payments, your lender may be able to raise your rate to a predetermined penalty, as written in the fine print of your contract. Even if you have a perfect payment record with one lender, a clause in our contract called "universal default'' may allow your credit card company to raise your interest rate because you were late with another lender. Lenders may even be able to raise your rate if they determine that you have too much debt on other cards or if you default on a loan.
Revolving Debt
Credit cards are called revolving debt. You'll have an overall limit to how much you can borrow, and each time you make payments, your credit limit "revolves'' back to that limit. This is debt that doesn't have a set monthly payment. The minimum payment due each month will change, depending on how much you're using the credit. The amount of the minimum payment varies from credit card to credit card. Generally, it s somewhere between 2 and 4 percent of your balance. So if you owe $2,000 and the minimum payment is 2 percent of your balance, the payment that month is $40.
Most credit card interest charges are based on what's called your average daily balance. Your balances on all the days of the month are added together and then divided by the number of days in the month.
Some credit cards allow you to make different transactions, such as cash advances. For these, your interest rate is probably different from-and higher than-the rate for a regular purchases.
When you make a payment on a revolving credit line - your credit card - part of the payment goes toward the interest charges, and part goes toward paying the actual balance you owe. Take that $40 minimum payment. Say the interest rate on this card is 15 percent. Divide the interest rate by 12 months, then multiply the number by your balance: (0.15/12) x 2,000. In this case, $2.5 will go toward the interest costs and $15 will go toward paying off your debt. (If you have more than one interest rate on the card, usually your payment goes toward the part of your balance that's charged the lower interest rate.) ' That's why it can take so long to pay down a credit card balance if you`re ma king only minimum payments. The $2,000 balance on a card with 15 percent interest will take 264 months, or more than 22 years, to pay off. For the $2,000 you borrowed, you'll pay more than $2,780 in interest charges-more than the amount you borrowed.
You have to make more than the minimum payments on revolving debt if you ever want to have a clean slate.
Installment debt
Installment debt is the kind of loan you'll have when you take on a mortgage or buy a new car. You can also take installment loans from your bank; these are generally called personal loans.
When you take an installment loan, you're borrowing a fixed amount of money for a certain period of time. You'll make monthly payments that don't change from month to month (unless you take an installment loan that offers a variable interest rate).
When you start making payments on installment loans, at first your payments are mostly interest. As the life of the loan goes on, more of your payment will start going toward the amount you borrowed-the principal-and less will go toward the interest.
In general, you'll find that installment loans have a much better interest rate than revolving credit. Another advantage of these loans is that because they have a fixed payment plan, you'll know how much you need to pay each month. This knowledge should help your budget