In an economy where debt is an important part of a consumer’s life, relatively few people have a keen understanding of how interest rates make or break your lifestyle, or how they vary widely among debt classes and consumers. Borrowed money is part of our existence, but do we really have a grasp on how interest rates affect our daily lives? The short answer is the bulk of the population, especially young people, are clueless.
Knowledge is sexy
Let’s start off with the admission that interest rates aren’t sexy, although having more money at your disposal is extremely exhilarating. While it may sound very “Schoolhouse Rock”-ish, knowledge is power and will help you thrive in today’s insanely complicated world. Take a moment out of the inane hours that you spend on social media to understand one of the most basic fundamental ideas behind our modern, debt-fueled economy: interest rates.
The cost of borrowed money
Borrowed money is essential because most of us would not be able to afford many essential items like cars, houses or an education without paying for them slowly over time. When you get a loan, you are required to a pay a fee for using that money, and that’s called an interest rate. The reverse occurs when you have money in the bank, they pay you interest on the money you have parked in the bank.
Once you owe money to a creditor, part of your payment goes toward interest, and the remaining portion pays off your original balance. Some loans frontload interest, so it’s best to read everything before you sign on the dotted line. Additionally, it is also important to understand compound interest. Basically, it means you end up paying interest on interest if you don’t pay down your loan. Compound interest can make your debt soar quickly.
Time to borrow or save?
We live in a time of rock-bottom interest rates, so being a debtor is less punishing, and being a saver is not greatly rewarded.
The Federal Reserve influences interest rates through its policies. The Fed brought interest rates to record lows to pump money into the economy during the Great Recession. Now, they are beginning to rise again, and rising interest rates reverberate through the entire economy. Interest rate policy is like an economic gas pedal; when rates are lowered, the economy speeds up, and when they’re raised, the economy slows down. Rising interest rates aren’t exactly good news for the young and the indebted, but the Fed must adjust interest rates to ensure inflation doesn’t get out of control.
Interest rates vary widely
Creditors charge us different interest rates based on our risk profile. Typically, the most common point of reference that lenders use to gauge our creditworthiness is our credit score. Essentially, if you have a good credit score, borrowing money can be a whole lot cheaper. If you have been careful and responsible, your thoughtfulness will pay off big when you purchase big-ticket items.
Deals on wheels
Unless you’ve been adopted by Daddy Warbucks, when you go buy a car, you’re probably going to need some borrowed money before you drive off the lot. In fact, financing is usually the most stressful part of buying a car.
Home is where the debt is
Let’s face it: Most of us would like to own property eventually. Unless you have some sort of financial windfall, the American Dream of owning your own slice of real estate requires a mortgage. Fortunately, if you do have good credit, you can get a huge government-backed loan to buy a house, and it may end up costing you less than rent every month.
The catch: To qualify for low interest rate mortgages, you need good credit. Yet again, our credit score comes into play, and a high credit score can save you a boatload of money in the long run. Even worse, many people who have little or no credit are often denied mortgages, condemning them to perma-renting.
Credit cards vary widely
Credit cards are in the same boat as car loans and mortgages. Basically, if you have good credit, you’ll pay much less than your counterparts who don’t have a solid credit history. Credit cards can often have sky-high interest rates because it’s an unsecured loan, meaning that there are no assets to seize if you stop paying your bills.
The average credit card rate hovers around 15%, which means not paying off your balance can be extremely expensive.
Student debt: Not cheap for anyone
Many of us graduate with student debt because there are few other options. Fortunately, student debt rates temporarily at 0% right now because of the pandemic. But if you ask people who are carrying large amounts of student debt from professional degrees like the ones that are required in the legal and medical fields (200k+), in many cases, their interest payments have been over $1,000 a month.
Obviously, most people don’t have nearly that much student debt, but even a typical $30,000 balance could cost you thousands of dollars a year, just in interest. If you don’t make enough payments to cover your interest, your balance will go up, and compound interest will pummel you financially.
Debt is an essential part of modern life, and can significantly improve your quality of life. But it is very important to understand interest rates, and how they can greatly affect the cost of borrowing money.
The elephant in the room in terms of interest rates and personal finance is always going to be your credit score. It is imperative to protect your score, and assure that your financial blunders today aren’t harming your economic future.
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