When I was a young adult and purchased my first ever “on my own” car, I had no idea what interest was. I just knew that I could afford X dollars a month on a payment and the dealers made that happen. They don’t teach us in school just what interest is and how it affects our daily lives. Here’s the bare bones version that will hopefully help you to make better decisions in life.
Interest goes two ways. Interest earned and interest spent. Let’s start with the fun one, interest earned. When you open a savings or checking account, they often tell you that it has a certain APY or Annual Percentage Yield. What this means is that money you have sitting in that account will earn interest.
Right now, interest rates are terrible. You’re lucky to find an account that offers 0.2% interest on the funds that sit in your account. If you average $1,000 in your savings account, this means you will earn roughly $2 on it throughout the course of the year if you leave it sit there. Big whoop right? In better times, interest rates were more like 5%, but this is where we are right now.
If you have a retirement plan at your job, you also earn interest on that and the rates are usually much higher than a regular savings.
Now, the not so fun part, interest spent. Interest spent is found in many sources: auto loans, credit cards, mortgages, furniture purchases, jewelry purchases and more. The one instance most people will be using interest in this format is an auto loan. Many factors are taken into consideration when they decide what your APR (annual percentage rate) will be for your auto loan. The biggest one will be your existing credit and credit score. If you have poor credit, meaning you haven’t paid your debts very well in your past, you will get a higher interest rate. Unlike the interest earned, this is a bad thing on interest spent.
Right now auto rates are running from less than 1% to 15%. If you have good credit and purchase a $15,000 car on payments for 5 years, your monthly payment (say they give you 2.5%) will be $266. The total interest you will spend throughout the life of the loan is $972. This means you spent $15,972 on that car. If you have poor credit and purchase the same car same way on a 12% interest loan, your monthly payment will be $344 and you will spend $5015 in interest. Now the car cost you $20,015!!!
This is a great example of why it is so important to know what interest is and how it can affect your life. Think of how much better a car you could have for $20,000? This means you need to work for a better interest rate, shop around for one and keep your credit in good standing.