This article is a superb introductory guide to interest
rates.
What You Need to Know About Interest Rates
By
Ken Austin
For all people shop around for the best rate, there are few
who have taken the time to sit down and add it all up. After all, why would you
bother? The answer is that understanding just how interest rates work can help
you see how important small differences in rates and payment amounts can be.
Interest Rates are Compound.
It is important to remember that what you owe is compounded – that means you
pay interest on the interest you owe from the month before. That means that if
you’re paying 2% per month in interest, you’re not paying 24% per year – you’re
actually paying 26.82%. Charging interest monthly instead of yearly is a trick
to make it feel like you are paying a very low price for your borrowing.
A Thought Experiment.
Here’s a question: would you rather have $1 million, or $10,000 in a savings
account earning 20% per year in compound interest?
Well, let’s see how that $10,000 would grow. After 10 years: $61,917. 20
years: $383,375. 30 years: $2,373,763. 40 years: $91,004,381. 50 years:
$563,475,143.
So after fifty years, you’d have over $500 million?! Well, not so fast. Of
course, you have to take inflation into account – if we say inflation is 5%,
then that money would have the buying power that $10,732,859 does today. Still,
that’s not a bad return on your investment of $10,000, is it?
That’s the power of compound interest, and the way the credit card companies
make their money (it’s also the way pensions work, and the reason the prices of
things seem to rise massively as you get older). Be very, very afraid of
compound interest. Or, of course, you could start saving, and be very glad of
it…
Compound Interest Adds Up.
Let’s work through an example on a more real kind of scale. Let’s say you
have an average unpaid balance of $1,000 on a card at 15% APR.
You will owe $150 in interest for the first year you borrow. However, this
amount is then added onto the balance, and interest is charged on that. The
second year, you’d owe another $172.50, for a total of $1,322.50. It goes on,
with totals like this: $1,520.88, $1,749.00, $2,011.35.
After just five years at 15%, you’d owe double what you borrowed. And after
10 years, you’d owe four times what you borrowed! Bet you weren’t expecting
that. If you let something like that carry on for long enough, you’ll end up
paying back that credit card for years afterwards, paying back what you borrowed
many times over and still not clearing the debt. Most people don’t work this
out, and feel that the payments must simply be their fault for spending too much
money to begin with.
One Percent of Difference.
One more thing. You might think there’s not that much difference between a
card that charges 15% APR and one that charges 12% APR. Let’s see the difference
the lower rate would make to that $1,000 borrowed for five years. Remember,
after five years at 15%, you owed $2,011.35.
At 12%: $1,120, $1,254.40, $1,404.93, $1,573.52… $1,762.34 after five years.
So you’ve saved $249.01 from that 3% difference in APR – in other words, you’ve
paid almost 25% less interest.
Ken Austin is the webmaster at
Debt
Consolidation Solutions and
Credit Relief Solutions
Article Source: http://EzineArticles.com/

