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June 9, 2016

How to not be Tricked by Interest Rates

Simple. Thrifty. Living.

When you’re paying off debt, don’t forget to take interest rates into account. If you don’t pay an account in full, you’ll get charged interest, and that can cause you to end up paying a lot more than the original purchase price.

Interest is a fee the bank charges every month for the use of its money. It is usually a percentage of the total balance due. For example,  if you owe $1,700 in credit card debt and the bank charges 22% interest, you will end up with a total payment due of $2,074.

Some people don’t take interest rates into account when planning how to pay off their debts. They figure that all the debt will be paid off eventually and that it is more motivating to repay smaller debts in full first than to take their time paying off a larger debt. However, if you use this type of approach you’ll end up paying more than you would if you organized your debts by interest rates.

Here’s an example to make things clearer:
Tom has three debts he wants to pay off: $5,000 of student loan debts with an interest rate of 7%,  $8,000 of credit card debt with an interest rate of 22% and a car note of $15,000 with an interest rate of 12%. If Tom organizes his debts by size rather than interest rates, this month his totals due look like this:

  • $5,350 (student loan)
  • $9,760 (credit card)
  • $16,800 (car note)

If he has $1,000 to spend per month on his debt payments and decides to attack one debt at a time, after another month his balances look like this:

  • $4,654.50 (student loan)
  • $11,907 (credit card)
  • $18,816 (car note)

If he organizes his debts by interest instead and takes that same $1,000 to apply to the highest interest debt, his totals next month will look like this:

  • $5,724.50 (student loan)
  • $10,687.20 (credit card)
  • $18,816 (car note)

While this example is over simplified, you can see that Tom saves a total of $149.80 by paying down his highest interest debt. That’s just over the course of one month — in a year he will save close to $2,000.

If you don’t feel comfortable with paying down your highest interest debt first, there is an alternative: lower your interest rates on your debts. There are two ways to do this:

Loan consolidation: You can consolidate your loans, which means that you sell a bunch of loans to one lender and pay back that lender, reducing your interest because you’re not paying interest on more than one loan. If you want more information about the best loan consolidation companies, this explains what they do and which ones are the best.

Balance Transfer: You can also transfer your balances to lower-interest credit cards so that you save on interest while paying down your debt. Here is a good list of the best 0% intro APR balance transfer credit cards that also offer rewards.

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