Over the past few weeks, I’ve been looking over our content for obvious gaps. While doing this, I realized that we have missed some of the more elementary lessons in personal finance. Among them: interest rates.
What is an interest rate
According to Investopedia, the interest rate is the amount a lender charges a borrower and is a percentage of the principal—the amount loaned. So basically, a bank, or some type of lender, loans you money and then collects interest on the principal of the loan. This interest is their cost of doing business, and, can be assessed higher, or lower, depending on the risk level of the investment.
The higher the interest, the more expensive the loan is for YOU, the borrower. The lower the interest rate, the cheaper the loan is.
What determines interest rates
Several factors play into interest rate assignments. For mortgages, the Federal Reserve sets an interest rate which sets the tone for mortgage interest rates. As the interest rates go up, consumer buying power decreases. This is a fairly common method to tamper inflation.
Another major factor in determining an interest rate is the borrowers credit score. A recent NerdWallet report highlights that a borrower with a credit score exceeding 781 can fetch a new car loan rate of 2.4% while a borrower with a sub-600 score can only manage a 10.87% rate. Clearly good credit pays off.
To put this in perspective, on a $30,000 loan for 72 months, the highly qualified borrower with a 2.4% loan will pay $2,241 in interest while the bad credit borrower will pay $10,969, a difference of $8,728. I don’t know about you, but I’m not too anxious to pay an extra $9k in interest.
Other interest rates
We’ve talked about mortgages and auto loans, but what about other loan products. Have you heard of payday loans? Those predatory products carry an average rate of 300%. That’s not a typo. Three-Hundred Percent. If you borrow money at 300%, you’re not a Wealthy Idiot, just a normal one.
How about credit card interest rates? These are typically higher and normally run over 10%. At the time of this writing, the daily average was 16.71%. There are some exceptions to this as some banks and credit unions offer very competitive cards. My everyday use card carries an interest rate of 7%.
All debt and interest isn’t bad
I’d be failing you big time if I didn’t throw this huge disclaimer out there. Low interest rates are a great way to leverage debt in order to build wealth. This is often seen in real estate but can be also be seen in small business.
Basically, you borrow as much money as possible for an investment, such as a rental house, with the expectation that the investment return will outrun the interest accrued. By doing this, you use less cash for investments and continue to use other peoples money (the bank). You can rinse and repeat this as many times as possible for rather lucrative gains. I wouldn’t tell you this unless it worked, considering I’ve done it a couple of times.
How to improve your borrowing
You’ve probably heard this before – but it’s true – the easiest way to get better lending opportunities is to increase your credit score. By doing this, you’ll make yourself more marketable to banks. According to Equifax, one of the major credit bureaus, the average credit score in the United States sits at 698, so there is definitely some room for improvement.
Keeping your debt-to-income (DTI) ratio low also helps with getting those low rates. And lastly, more income always helps. If you earn a W-2 income of $250k a year, the bank will certainly like the prospect of lending you money. Money talks.
Best steps to improve your financing prospects
- Establish good credit. You’ll want to take out a personal loan or a low-limit credit card to start building early, ideally by age 16 or so.
- Don’t overspend on credit cards. Really high usage rates can turn off prospective lenders.
- Earn enough money to make banks drool over you (figuratively, of course).
- Always pay back your loans and don’t accrue lots of credit card interest.
- Shop around for the best rates. Their are tons of sites that review the best mortgages, credit cards, and auto loans so you don’t have to. Do some research.
If you truly care about your credit and take the time to understand it, there is no reason you can’t have a score in the high 700’s, or even low 800’s!
