If you have been keeping up with the news lately, you may have noticed that there is a lot of consternation regarding what the Federal Reserve Bank, or the Fed, is doing with interest rates. However, these “big moves” are usually decimals of a single percentage point, leaving those that are not experts in finance scratching their heads. So if such a small change can send shockwaves through the entire financial system what kind of an effect can your own effective annual percentage rate have over the life of your personal debt? What is the big deal about interest rates anyway? Let’s take a closer look and find out what all the fuss is about.
What Is APR?
Annual percentage rate (APR) is the annual rate of interest charged to borrowers and paid to investors. No matter where you have borrowed money from or for what purpose you have taken on the loan, you will be expected to pay off the entire principal with interest. While this is a simple enough concept, it is surprising how much jargon is used in the financial services industry to obscure what the ultimate cost will be when that final payment is sent.
Generally, the only information that is given upfront is the percentage of the principal amount that will be added every year. So a $10,000 signature loan with an APR of 5% will add $500.00 of interest on an annual basis if the interest is only compounded annually. However, this is rarely the case and interest is usually compounded monthly, adding to the principal if the amount of the payment is insufficient to fully service this interest. With this in mind, even small amounts of interest in the decimal range can compound several times-over throughout the life of longer-term loans such as mortgages.
How Small Changes In Interest Rate Can Benefit You
While thinking about the amount of money you may have to pay to service your debt can cause significant headaches, interest rates can also be your best friend. As APR determines how much you will have to pay, Annual Percentage Yield (APY) determines how much you stand to make from money in your accounts. As this is understandably lower than the APR of your debt is bound to be, many respected financial advisors prioritize paying off debt to accruing savings.
However, if interest rates suddenly rise or fall you can take advantage of the situation to improve your debt position. You may have the opportunity to refinance part or all of your existing debt at a lower rate than the going rate at the time you initially made the loan agreement. There may also be opportunities to borrow at lower rates with variable rate APR rather than a fixed-rate at a time when interest rates were high. Even a 1% difference can make a huge difference over several years of payments.