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The Impact of Understanding Interest Payments on Your Finances

The Impact of Understanding Interest Payments on Your Finances

Interest rates have been in the news over the last year. As the country battles against inflation, raising interest rates is seen as the antidote. However, every interest rate decision at the Federal Reserve impacts the money in your pocket.

Currently, the U.S. Federal interest rate is 5.5%, which provides a guide for every lender in the country to determine the interest rates charged to customers. As many Americans struggle with their finances, this guide discusses interest rates and their impact on your finances.

What are Interest Rates, and How Do Interest Rates Work? 

Interest rates represent how much a lender will charge a borrower for credit. It’s always expressed as a percentage and is based on the size of the loan and various personal factors, such as your credit score.

Most loans charge interest in an annual percentage, known as your Annual Percentage Rate (APR). In practice, if a loan has an APR of 7%, you can expect to pay 7% of the principal in interest every year the loan remains active.

But it’s not all bad. Interest rates can also apply to your savings, known as the Annual Percentage Yield (APY). If the APY on your savings account is set at 4%, your money will grow by 4% every year.

Understanding Interest Rates

The easiest way to think of interest rates is as a charge to the borrower for using a particular asset. In most cases, the asset is cash, but it can also be physical assets, such as property, vehicles, and various consumer goods. An excellent way to express interest is “the cost of money.”

If you’ve taken out an ordinary loan, the interest will always be applied to the principal or the amount the loan is worth. In these scenarios, interest rates are essentially the cost of acquiring debt for the borrower. From the lender’s perspective, the money to be repaid is the rate of return.

So, what does this look like in practice? 

Let’s say you take out a $300,000 loan with your bank. The chances are you’ll be charged what’s known as simple interest. For argument’s sake, we’ll say you have a 4% interest rate on your loan. 

The amount you’ll end up paying is calculated thus:

Principal x Interest Rate x Time = Total Amount Repaid

Since you’ve taken out a long-term loan of 30 years rather than just a one-year loan, your calculations would look like this:

$300,000 x 4% x 30 = $360,000

Your total annual interest rate on this loan would be $12,000, which is 4% of $300,000. However, over 30 years, this becomes $12,000 per year. By the time you finish paying off your loan, you will have paid $360,000 in total interest. 

And that’s how banks, mortgage providers, and other lenders turn a profit by giving credit to the public.

What’s the Maximum Interest Rate in the U.S.?

 As you can see from the example above, interest repayments can have a massive influence on your long-term future. It underlines the importance of calculating what a specific rate on a lending product will mean for you.

Note that no federal legislation caps how much lenders can charge in interest. Instead, every state has its own approach. Your state may or may not have maximum interest rates depending on where you happen to be.

For example, in New York State, the maximum interest rate that can be applied to a loan by law is 16%. In California, this number is just 10%.

However, Alabama is one of the country’s only states with no interest rate laws. If you live there, creditors can charge whatever they want. Unlimited interest rates are one of the major reasons people turn to debt relief programs in Alabama, meaning it’s vital to tread carefully when taking on debt.

How Interest Rates Impact the Average Joe’s Finances

Understanding interest rates is one thing, but what influence do they have in the real world? Let’s review some of the most prominent examples of how interest rates impact Americans.

1.Borrowing Costs

Interest rates are directly linked to the cost of borrowing money. Higher interest rates mean that the cost of borrowing increases. If your interest rate goes up, expect to spend more every month servicing your debt.

2. Savings Accounts

According to a Forbes report, the average American has $65,100 in personal savings. If your money is locked in a savings account, rising interest rates will increase the amount your bank pays you to keep your money where it is. In other words, you can make your money grow faster.

3. Investments

Interest rate increases will also influence any investments you have. In the stock market, prices decline as interest rates rise because businesses borrow less. It’s also not uncommon for companies to rein in spending.

The same goes if you happen to hold bonds. Bond yields and interest rates move in opposite directions, so when interest rates rise, the value of your account will fall. 

4. Retirement

Older Americans have to be extremely careful when it comes to interest rates. Significant interest rate changes can change your retirement plans due to the returns you get from your retirement accounts.

5. Refinancing

Debt refinancing is one of the best ways to get the lowest rate possible. When interest rates fall, this typically opens up opportunities to refinance your existing debt at a lower rate. However, the opposite is true when rates rise.

Shop Around for the Best Rates

Lenders will determine your interest rates based on the broader market, how much you want to borrow, and your credit score. But the best way to get the most competitive rates is always to shop around.

With so many lenders, small and large, there’s ample opportunity to shop around and get rock-bottom rates on your next loan. However, knowing what a specific rate will do to your finances matters.

What are your top tips for getting the lowest rates possible?

Published by: Martin De Juan

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