Financial Literacy

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April is financial literacy month. When thinking about finances one key factor is interest rates on money that is borrowed. Almost everyone in the United States will borrow money for an expenditure, and knowing what type of interest rate the loan is subject to is important. The two main types of interest rates are simple and compound.

An explanation of these types of loans as they are traditionally used are as follow: On a simple interest loan the borrower pays interest only on the amount borrowed. On a compound interest loan the borrower pays interest on the amount borrowed plus the interest that accumulates on the loan every period. There are variations of each one of these such as interest that is charged on a daily basis rather than a monthly basis.

Typical loan types and their interest rates

Automobile loans are typically simple interest loans. The purchaser agrees on a price, and the financing comes with an interest rate that is calculated along with the purchase price to comprise the payment. For new vehicles sometimes special interest rates are offered as an enticement to purchase. Examples are 0% interest for 36 months, 2.9% interest for 60 months, etc. If the purchaser is in a financial situation where they can afford to pay for the new vehicle these can be great options if they do not pay too much for the vehicle, are able to pay it off during the term, and are able to make the payments on time.

Credit Cards typically use compound interest rates, and most of them are now operating with daily compound rate. So if you look at the annual percentage rate of interest versus the actual interest rate, the borrower actually pays more than the annual percentage rate. If the borrower takes the annual percentage rate and divides it by 365 that will be the daily rate. Generally, each day the bill is not paid the interest calculated from the daily rate will be added to the principal owed and the interest for the next day will be calculated on the full amount owed the next day thus compounding the interest. As one can see carrying a balance on a credit card can become very expensive.

Mortgage Loans – The traditional mortgage loan generally operates like a simple interest loan. The interest rate is divided by 12, and then the loan balance is multiplied by that number to provide the actual amount of interest owed. Many people purchasing a home will use this type of loan as it provides an equitable way to purchase a home if the borrower is not paying cash. There are other types of loans available such as adjustable rate mortgage loans (these typically adjust for a period until they lock into a rate such as three years and then a lock).

Although calculating the interest rate on money to be borrowed (or already borrowed) may seem to be difficult, taking the time to understand it can help guide the best choices for financial prosperity.