Budgeting, Tips

Understanding Debt & Interest

Do you understand how much you are paying in interest each year on your debts? Understanding debt and interest will help you get motivated to get out of debt. When you see the information, you will see how you could be spending your money in other ways.

Before taking out any loan, you should understand exactly what you will be paying in interest, APR, and how long you will be paying. There are some easy to use debt calculators online that will calculate your interest.

Interest. Interest is the extra amount you will be paying for using someone else’s money. When you have a savings account, interest is the amount that you are receiving for letting someone else borrow your money. Savings rates are usually much lower and so most debt-free people paid off their debt first, then built savings.

APR. This stands for Annual Percentage Rate. This is the interest rate you are paying. You should get the lowest APR you can. APR takes into account any loan fees and compounding interest. When you understand APR and increase your credit score, you can use those as tools to pay less interest. The chart below shows how much interest you pay at different interest rates (in blue). The red shows how much interest you would pay if you paid a $2,000 lump sum payment at the first of the loan but kept paying the same amount.

How long will you be paying for these loans? The chart above calculates interest on a 5 year loan of $10,000. Ask yourself if you can really afford to make those payments for 5 years. By paying upfront of $2,000, you can reduce the payback period. The 20% loan only took 45 months to pay off instead of 60. That is paying the same payment but putting down $2,000 upfront.

If you also add extra payments, you will be out of debt a lot quicker, increase your credit score, and be able to save yourself hundreds or thousands of dollars. It is so important to understand these aspects of debt and interest as you start on a journey to lower/eliminate debt, increase your credit score and learn how to save.

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