Interest (or, in some cases, dividends – more on that later) is a significant factor when making financial decisions. Sometimes, it can be the most important factor.
In concept, interest is simple, but dual-sided. For example, when financing a major purchase, the lower your interest rate is, the less money you pay in total over time. However, when it comes to savings and general investments, the higher the interest rate, the more additional money you earn over time. It’s important to understand the implications of both before making borrowing or investing decisions.
Paying Interest on Debt
Any debt you choose to incur will come with an interest rate, which determines the additional money you will pay on top of your loan until the debt is paid off in full. This is true of auto loans, mortgages, student loans, credit card debt, and more. For example, credit cards are unsecured and often carry comparatively higher rates – sometimes more than 20 percent*. That means if you make a $100 purchase and allow interest to accrue, that purchase will cost more than $100 (exact amount varies based on APR). Comparatively, student loans tend to carry a much lower interest rate – between three and seven percent, usually.
In the case of a mortgage, interest rates fluctuate with the market. As a result, you may lock in an interest rate depending on a) how the market is performing and b) your credit score. Naturally, it’s in your best interest (no pun intended) to shop around for the lowest interest rate to save significant money over time, considering that most homeowners in California finance hundreds of thousands of dollars and carry their mortgages for the full term. A lower interest rate can quite literally save you tens of thousands of dollars, or more!
Key Takeaway: The best way to increase the likelihood of regularly qualifying for a low interest rate is to actively maintain and monitor your credit, and prove yourself to be a responsible borrower.
Earning Interest on Investments
Earning interest is different than paying it. When you borrow money, you pay interest. When you invest money, which is a form of lending it to someone else, you earn interest.
(Before moving forward, it’s important to note that some financial institutions technically don’t pay interest – credit unions like SAFE, for example, pay dividends. These two concepts are similar, but there are a few important differences. The short explanation is that interest is contractually guaranteed, whereas dividends depend on the profitability of the institution in question. This article explains the differences in greater detail.)
Depending on the method you choose to invest – whether it’s in your savings, a certificate, or something else – the interest/dividends gained on your investment may fluctuate. Additionally, some forms of investments are quite safe, though they may yield less interest/dividends in the long run; however, other forms of investments carry more risk. A financial expert should be consulted when deciding how to invest, so they can advise you based on your risk tolerance.
Regardless of whether you are borrowing money in the form of debt, or attempting to earn money in the form of an investment, interest is an extremely important concept to understand and account for in your decision making. By looking at the picture in its entirety, you can better avoid common financial pitfalls, such as accumulating more debt than planned, helping to ensure you remain on track to meet your long-term financial goals.
It’s never too early or too late to seek advice regarding your next big decision or your overall financial picture. SAFE is always here and ready to help you improve your financial well-being.
Financially speaking series:
Part 1: Why is credit so important? | Part 2: How do you establish credit? | Part 3: How do you repair credit? | Part 4: How do you monitor credit? | Part 5: What is interest? | Part 6: How does credit affect you?