As featured in the Finances FYI section of the the Seattle Times
By 1st Security Bank
Interest payments are nearly unavoidable for adults. Credit cards, mortgages and student loans all charge interest on outstanding balances, and the money spent can add up fast.
For those new to the world of interest rates or just in need a refresher, here is an explanation of the main types of interest rates, when you’ll see them and the best ways to try and reduce your overall interest payments.
Good news first
Despite the negative connotation you may have with the term, it’s possible to receive payments from interest yourself. Interest-bearing savings accounts and other financial tools exist to put your money to work for you. These accounts can often be helpful to offset expenses you have, like a mortgage or student loan debt, throughout the year.
Receiving interest is exciting, but keep in mind that you’ll owe the majority of interest you incur to a lender. Here’s a rundown of how interest works and the different kinds you may encounter.
How interest works
Interest is simply an additional payment owed on top of the principal to a lender in exchange for access to a line of credit. Interest fees vary widely depending on the type of loan, but a percentage is charged off the principal balance and is due with each billing. Here are the main kinds of interest you need to know:
While you likely will never get the prime rate yourself, it’s the basis for all other types of interest and is commonly mentioned during financial news programs. Prime rates are given to preferred customers and are linked to federal bank rates — so it’s essential to be aware of its fluctuations.
One of the most common types of interest is a fixed rate. This means your percentage will never change, providing stability for borrowers and lenders alike.
As the name implies, variable rate interest is subject to the market and will change throughout your loan. Despite the lack of stability, they can be beneficial to borrowers if interest rates decline in future years.
Annual percentage rate
Also known as APR, this is a way lenders show the total cost of each year of the loan to a borrower. This number includes fees and other costs associated with borrowing, so it isn’t strictly the total interest added up each month.
The interest rate is the fee you’re paying to take out a loan from the lender. Home mortgages, for example, will include closing costs, personal mortgage insurance, and other fees in the annual percentage rate, so using APR can provide a much clearer picture of your obligations.
How to keep interest payments low
Although interest rates are everywhere, there are simple ways to try and reduce your monthly costs associated with them:
Don’t carry balances
While this is likely not possible for large sums like mortgages and student loans, paying off your entire credit card balance each month is the surest way to avoid interest. Without the monthly carry-over, you’ll kiss credit card interest fees goodbye.
Multiple monthly payments
Most credit cards calculate interest fees based on the average daily balance. Making payments every two weeks instead of monthly is a great way to lower your average and interest costs.
Pay higher rates first
If you have balances on multiple credit cards, start working to eliminate the balance of the card with the highest rate first. Paying reduced interest fees each month will enable you to pay off the principal faster.
Shopping for lower rates and moving credit balances to one card is another useful trick to reduce interest fees. This option is typically reserved for people with above-average credit, and extra costs are often associated with the balance transfer.
Many companies offer extended 0% interest periods for debt consolidation, so any transfer fees quickly pay for themselves. If you can pay your balance off before the 0% expires, you can save significant money long-term.
Understanding interest rates can make financial decisions more straightforward and will help you reach your goals. Be sure to read the fine print on any loan or credit agreement you sign to know precisely what type of interest you’ll be paying and at what rate.