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  • Writer's pictureDavid J. Perrotto

How does interest work?

One of the most common questions I get asked in my profession is “How does interest work”? To understand how they work, we’re going to break down each area of loans.

First let’s go over quick how normal people go about getting debt. Our easiest form of debt is going to come from credit cards. Credit cards have no collateral if we default on them, so the bank has to take into consideration, if anything negatively happens to us, that would be the first debt we wouldn’t pay. The average interest rate ticks in about 15%. Next, we have auto loans. Auto loans use the car you buy as collateral. Now that you have something that can be taken back if you don’t pay, the interest rate is much lower. The average rate comes in at 4.21%. Lastly, the largest loan most people ever take, is of course, their home. Even though that loan is very large, you have a large asset that creates the collateral for your loan, the average 15-year mortgage as of September 2017 was 3.39%.

So what does this mean? Let’s use your credit card as an example. With a 15% interest rate, and 1000 dollars of debt, if you were to pay 25 dollars a month, it would take you 63 months to pay off the debt, and you would have paid the bank an extra $538.62 dollars. So let’s break down the payment, since you are giving them 25 dollars a month, why isn’t it going down more. Because of the balance, 150 of that 1000 dollars is being charged as “interest”, which is the money the bank is charging you to use their money. So in reality your 25-dollar payment you made on your 1000 dollars of debt really breaks down to 15.00 in interest and 10 dollars in principal. So next month you would see a balance of 990 dollars. The next month you make a payment of 25 dollars, you would pay 14.85 in interest and 10.15 in principal. Now let’s put this all together for the average American family.

The average American family has $5,700 of debt. If we assigned paying 300 a month to this debt, roughly 70 dollars would be going to interest a month, and it would take 22 months to pay the debt off in full. The average car loan this family has is 30,000. This family pays 500 a month for their car, and their term is 68 months. Remember this is all the average American family. Of their 500 dollars, roughly 99 is going to interest. So as you can see, things start to add up, just on your credit card debt and auto debt, the average American family is spending almost 200 extra a month on literally nothing. 200 dollars a month into a retirement account would do incredible things to your retirement chances.

One of the most important things you can do to financially get ahead, before investing, before saving, is paying down high interest debt. If you need help budgeting, don’t hesitate to give your advisor a call.

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