Whether you are going to school, buying your first home, or just swiping a credit card, you may be entering an agreement to receive money now, and pay it back later. I don’t know about you, but if someone were to ask to borrow money from me to repay at a later date, in many instances I would think “what is in it for me?”
What is in it for me? I would have to forego using this money for myself until you paid it back in the future (assuming that you would pay it back!). There would need to be an incentive; motivation to take this risk. There is also the risk of inflation; the money you repay is not worth as much as the money I gave you.
Well in just about any situation, there is incentive for this type of agreement, and that incentive is interest. The more risk there is involved in the loan, the higher the interest rate there will need to be to compensate the lender for taking on that risk. If you were to take a small loan to purchase a car, the interest rate may be lower, because the lender could take the car as collateral in the event of default. My car loan was 6% interest on about a $5,000 loan. The interest on that was about $300. Let’s say instead of buying a car, I wanted a business loan. Well there may not be collateral there, and the interest rate may end up being higher to compensate. The same $5,000 borrowed at say 12% interest rate is $600. These are estimates, depending on the payment terms the exact interest amount may vary!
This may seem like small potatoes, but when you talk about mortgages it can be quite a large difference. $200,000 at 5% would be $10,000 in interest paid, whereas $200,000 at 7% would be $14,000 in interest paid. Also to note: what I am calculating here is simple, one-time-charge, interest. In reality they charge a percentage on every payment, which can make the overall interest paid quite LARGE!
Lastly, credit cards not only charge you interest for taking on the risk of default, but also charge you for the convenience. Some credit cards charge up to 20%+. You would only need to rack up $1,500 in credit card debt at 20% to have to pay the same amount in interest as you would pay for the $5,000, 6% interest rate, car loan mentioned above. Let's say you were willing to spend $1,000 in interest total. The graph below shows how much you could get, depending on the reason for the loan!
To us, interest is the cost of obtaining the money now. To the lender it is an investment. Invest wisely, but also understand the terms to your borrowing. Shopping around a little bit can save you lots of “points” on an interest rate, and lots of $$ for your wallet (or purse).
When it comes to taxes, the percentages can get even higher, but that is another topic!
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