What is Interest & Why Does it Matter?
Large purchases don’t come cheap. A TV, speakers, and the miles of cables and cords you need to hook everything up can run you a decent amount of money — but if you use your credit card to pay for them, they can end up costing you even more than you bargained for in the long run. Why? Interest! High interest rates are a challenge most of us face, but one you can overcome with a little know-how and proper financial planning.
Most consumers know interest as that extra fee that gets charged to their account when they don’t pay off their credit card balance every month. Or, perhaps you’ve taken out a home loan, and you pay an interest charge on top of paying back the principal. Interest charges are part of how financial and lending institutions make money. But there are ways for consumers to save money despite these common charges. And the first step to keeping more money in your bank account is by understanding the concept of interest a little better.
Keep reading for a full overview or use the navigation links below to skip directly to a relevant section.
- What is Interest?
- Types of Interest Rates
- What is Revolving Credit Card Debt?
- What is the Avalanche Method?
- What is the Snowball Method?
- What Else Should I Know About Interest?
What is Interest?
At its most basic level, interest is the percentage of either a deposit or a loan balance, that is paid to the financial institution (or bank account owner) for the privilege of financing or using their money.
Types of Interest Rates
There is more than one kind of interest rate, but we’ll just talk about the two you’ll run into with revolving credit and common loans like mortgages: fixed interest rates and variable interest rates.
Fixed Interest Rate
A fixed interest rate is exactly what it sounds like: an unchanging rate tied to a line of credit or loan that has to be paid alongside the principal amount. Fixed rates are common because it’s a transparent agreement between the lender and borrower. The benefit of fixed interest is that it’s simple to calculate and easy to comprehend.
Variable Interest Rate
Some interest rates change and for this reason, they’re called variable interest rates. Variable interest rates are usually tied to the changes happening on the broader scale of interest rates, aka the prime interest rates. In some cases, consumers with loans can benefit from a variable interest rate if the prime interest rate decreases. In turn, the consumer pays less in interest charges. On the other side of that coin, the prime interest rate might also rise, which leads to the consumer paying more in interest charges.
What is Revolving Credit Card Debt?
When you use your credit card, you’re borrowing money from the bank with the understanding that you will pay it back in a timely manner. If you purchase an item for $100 on your card with a 10% interest rate, failing to pay off your balance on time means you owe that $100 plus the 10%. At the end of the day, that item really cost you $110.
If you carry balances from month to month, that debt can really stack up and eat away at your carefully planned budget. It can be a tricky subject to grasp, but if you’re having difficulties rest assured you’re not alone. Thankfully, there’s a light at the end of the tunnel. There are two ways to approach paying off your debt: the snowball method and the avalanche method.
What is the Avalanche Method?
We all have that one debt that seems insurmountable. Whether you’re paying off student loans, a vehicle or a home, high interest rates can make debt feel like a permanent part of your budget. If tackling a big challenge head-on is your style, the avalanche method may work for you.
With this method, you identify the debt with the highest interest rate and put all of your allocated funds toward paying it off as soon as possible. This is the debt that is costing you more and more as time goes on, and it may take quite some time to fully pay it off — but once that debt is off your plate, you suddenly have a lot more money to work with. You can then disperse those funds as you see fit to pay off your smaller debts.
What is the Snowball Method?
The avalanche method is most likely the method that will cost you less interest in the long run. That said, the snowball method is considered a great choice for those who need help staying motivated.
With this method, you start by repaying your smallest amount of debt first. Once that’s taken care of, you can apply that freed up money toward the next largest debt, and so on. This is a great way to pay off your debt if you thrive on short-term accomplishments. It feels great to pay off one source of debt in its entirety, and those positive feelings can spur you to take on the next challenge.
What Else Should I Know about Interest?
Debt is nobody’s favorite topic, but it can be therapeutic to talk about. Mint’s very own Ashwin Khurana hit the streets of Indianapolis, IN, to ask people about their relationship with their credit cards.
Besides watching the videos on interest, Mint has tons of resources you can check out to bulk up your financial knowledge. You can learn more about compound interest and how to earn it to refinancing your mortgage.