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How Interest Rates Work

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Financing big purchases with a credit card, home loan or auto loan can be an efficient way to manage your budget. Here’s how interest rates are calculated.

Financing big purchases with a line of credit (like a credit card, home loan or auto loan) can be an efficient way to manage your budget — if used responsibly, of course. But with those options comes additional interest charges that get tacked on each month until you pay the balance in full. So, as you’re comparing your options, it’s important to factor in the interest you’ll be charged as well so you can plan accordingly.

But how do you know how much interest you’ll be paying? The interest rates depend on several factors, including the type of financing you’re looking at, as well as federal interest rates and your credit.

Why Your Credit Scores Matter

Whether you want to take out a loan to help you buy a car or you are trying to figure out what interest charges will be with a new credit card, your credit scores will play a role. Why? They’re typically going to help determine the interest terms and conditions you qualify for. So, before you start shopping around for any new lines of credit, it’s a good idea to find out where your credit stands. Best of all, you don’t have to pay to do this and checking your own credit won’t hurt your scores: You can get a free credit report snapshot on Credit.com. It’s easy to read and understand and will give you insight into any problem areas you may want to work on before getting a loan or new plastic, as the better your credit, the better the terms you’ll be eligible for.

Credit Card Interest Rates

Once you find out your credit scores are, and what credit cards you’re most likely eligible for, you’ll want to compare the interest rates that come with each. Why? Because this will tell you how much carrying a balance on a credit card will cost you.

Take a close look at the fine print and find out what is listed as the card’s annual percentage rate (APR), which is the yearly interest rate charged on the credit card.

Many credit card issuers use a daily periodic rate (DPR) to calculate interest charges on a credit card account whenever you carry a balance. The formula for the DPR is a simple one. It’s the APR on your credit card for new purchases divided by 365.

Your average daily balance and the number of days in your card’s billing cycle are other important factors in determining your monthly finance charge. The monthly finance charge is the amount you pay for carrying a balance on a credit card each month.

If your credit is good, and you’re looking to finance a large purchase, opting for a card with a 0% interest rate for several months is a good option to consider. To use this card as effectively as possible, it’s a good idea to budget carefully and make sure you are able to pay off the full amount before the introductory period ends and the card’s much higher APR takes effect. This way, you won’t have to pay interest charges on your purchase. Keep in mind, however, that there may be other fees associated with these cards (or any credit cards, for that matter) so it’s essential to read the fine print for all the details.

Home Loan Interest Rates

When shopping for a mortgage, you’ll want to check out loan’s APRs – which includes the interest rate plus certain fees. You’ll find this information, which indicates that amount of interest you will pay over the full length of the home loan, in the description of the loan’s terms in the paperwork given to you by a lender.

You will be charged an origination fee on a mortgage and possibly other fees, like mortgage insurance. These fees can be paid separately, upfront or they can be rolled into your home loan. While they won’t be part of the interest rates, they are important to consider as you budget for mortgage payments. Make sure you understand how fees are handled with your home loan and how they may be factored into your monthly mortgage payment.

Auto Loan Interest Rates

Most auto loans use a simple interest formula when calculating your monthly car payment. With a simple interest loan, your loan’s interest rate is only applied to the principal amount that you borrowed for your car loan. Paying ahead on your principal payments will help to lower the financing costs of an auto loan.

This article has been updated. It was originally published on September 30, 2014.


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