I received an email from a reader who wanted to know what is considered a bad APR, but this is really the wrong question. Instead of focusing on what is a bad or good APR, you should be looking at the APY. Here’s why.
Focus on APY instead of APR.
First, let’s define the Annual Percentage Rate, or APR. The APR of a loan is the annual interest rate that is charged for borrowing. This is often portrayed as the total cost of borrowing money per year (excluding 1 time fees or application costs), rolled into a single number. The idea is that it makes comparing loan offers much easier. The problem is that it is not always accurate.
For example, let’s consider a simple credit card offer. The offer states that the interest rate (APR) of the credit card is 12%. But once you look at the details, you see that interest is compounded monthly.
This means that were you to carry a balance on the card for a year, the actually interest rate you would end up paying is 12.68%.
This is where APY comes into play.
APY is the Annual Percentage Yield and is the same concept as APR except that it takes into account the effect of compound interest throughout that year.
*** WARNING : MATH AHEAD ***
Here’s the formula for computing the APY of a loan:
APY = (1 + periodic rate)^(periods) -1
in the example above, the periodic rate is 1% and the number of periods is 12, since the interest is compounded monthly and there are 12 months in a year. This makes the rate charged per month 1% since the APR is 12% per year (12% / 12 months = 1% per month).
So let’s look at the two costs of borrowing – the APR vs. the APY…
To keep things simple, we’ll assume a balance of $10,000 on the card carried for the year…
APR.
Computing the cost using just the APR gives us: $10,000 * .12 = $1,200 per year (or $100 per month).
APY.
Now running the same $10k through the Annual Percentage Yield formula [APY = (1 + periodic rate)^(periods) -1] gives us:
(1 + 0.01)^12 -1 = 12.68% OR 12.68% * $10,000 = $1,268 per year (or $105.66 per month)
So, what does this mean?
If a person has a balance of $10,000 on this credit card for a year, it’s the difference between what the offer leads him to believe it will cost and the actual cost is $68 per year, or $5.66 per month.
Not a big deal, right?
Maybe not for a $10,000 loan. But when you’re considering the cost of a mortgage in the hundreds of thousands things add up pretty quickly.
Note: These are simple examples to illustrate the difference between APR and APY and the importance of knowing which to pay more attention to when applying for a loan.
The other important thing to consider is what is this loan for?
Interest rates differ by loan type.
It’s impossible to answer the question of “what’s a good (or bad) APR” because there’s no context given. Is this a loan for a new car, a credit card or a mortgage?
For credit cards, 16% may be average but if you have excellent credit you may get an offer for 8%. While the 30-year mortgage rate is currently at historic lows of 4%. New car loans may be as low a 0% for certain models, or as high as 10% for borrowers with a poor credit score.
If you take away only 2 things from this article, make it these:
APR is relative to your credit score and the type of loan
APY is really a better gauge of what you’ll pay than APR.
In the end, shop around and compare by APY whenever possible.
Most of the wealthy in America are 1st generation wealthy, meaning they earned their wealth and didn’t inherit it. So who are The Rich? They are mostly entrepreneurs and small business owners.
According to Thomas Stanley and William Danko, “Wealth is what you accumulate, not what you spend.”
What they learned about America’s wealthy is summed up in this quote from the book:
“It is seldom luck or inheritance or advanced degrees or even intelligence that enables people to amass fortunes, wealth is more often the result of a lifestyle of hard work, perseverance, planning, and, most of all, self discipline.”
There are many lessons in this book, and that quote touches on a few of them. The most important lesson is that you don’t need to be born into the right circumstances to become wealthy. It sometimes takes luck, but mostly takes self discipline and perseverance. In short, stop finding excuses – you too can become rich!
I know, that probably sounds a bit like an infomercial for some get rich quick scheme, but it’s not. They never say you can do it over night or that its something you can do on the weekends in your spare time. Quite the contrary. It takes years of planning and discipline, but that’s not to say it takes as much as a career or full time job. You just need to have a plan and keep at it.
OK, enough cheerleading about how you can do it… let’s answer a basic question: What is wealth?
The definition of wealth.
Wealth can be defined in many different ways, but in its most common use it equates to a person’s net worth. That is, the value of everything a person owns, minus what a person owes.
That’s overly simplistic, but you get the idea. Having a fancy Mercedes Benz in the driveway doesn’t make you any more wealthy if you owe more on the loan than the car is worth… or if you’re leasing it and don’t actually own it at all. That’s because the car is a liability, not an asset. An asset is something that either puts money in your pocket, or can be sold to generate cash. A liability is something that costs you money.
But there’s a difference in assets too. Some are liquid, and some are not. Stocks for instance are generally more liquid than real estate, since you can sell a shares of a stock much easier than you can a house.
How the wealthy view (and use) money.
The wealthy get rich by maximizing their return on investment. They may still spend big bucks on discretionary items, but they view those purchases as investments, not mere expenses. They are more apt to maximize quality and value, regardless of price. But that’s not the same as buying expensive name-brand merchandise for the sake of owning expensive name-brand merchandise. This has especially been true of the rich during the recession.
There are definitely plenty of people with money who act rich, but when their finances are viewed more closely it’s clear that they are only suffering from Affluenza (The All-Consuming Epidemic).
You may think that the wealthy eschew debt and pay only in cash, but that turns out not to be the case entirely. Stanley and Danko found that most American millionaires tend to pay for large ticket items like cars, homes and boats with cash and to the extent that they use debt it is for investment purposes. This is likely a big difference between the middle class wage earner and the millionaire, but if the wage earner can get to a point where he can buy those big ticket items without debt, then he’s well on the road to a more financially free lifestyle if not the road to riches.
Tips for increasing your wealth.
OK, enough about how we’re different from the rich. Here’s how to become more like them financially:
Don’t look to debt to fund your lifestyle – this includes getting a college degree. Going $30,000 into debt for a degree and getting a job with an income ceiling of $30,000 probably isn’t worth it in the long run.
Have cash on hand to cover your unexpected expenses (emergency fund).
Live below your means – spend less than you earn and avoid Lifestyle Creep !
Plan – plan for today, tomorrow and 30 years after retirement.
Diversify – invest in mutual funds and bonds, not just cash. Add exposure to commodities and real estate.
Don’t use credit for purchasing – unless you can (and do!) pay off the balance each month!
If I had to distill the lessons learned in The Millionaire Next Door into one simple concept it would be this:
Break out of the debt cycle; plan, save and work to avoid going into debt for any reason.
If you master that, you’ll have the tools and resources on hand to accumulate wealth instead of payments.
I don’t have a lot of time (still cleaning up after our messy houseguest, Irene) so here’s a quick post… the U.S. National Debt – in pictures!
In case the sheer magnitude of the U.S. deficit was lost in the political circus that was the “debt ceiling crisis” of the summer of 2011, here comes an excellent site to bring it into focus.
They start with a $100 bill, then jump to $10,000 and so on, all the way to the $15 trillion deficit that the big spenders in Washington D.C. will hit by years end. It doesn’t stop there though, it keeps right on piling up to the $114.5 trillion (unfunded liability) skyscraper that would dwarf the World Trade Center.
(click for larger view)
That $114.5 trillion is all the promised entitlements (social security, medicare, medicaid, Obamacare, etc..) that the government does not have the money for.
We can argue about the specifics of the metrics used for figures like the above, but just consider the $1 trillion graphic for a moment. The Obama administration has run a yearly deficit of *over $1 trillion* since taking office. That’s more than enough $100 bills to fill a football field – every year !
(click to view larger image)
And yet the political class insists on pretending they don’t have a spending problem.
This is a common question, as well as a common misconception. The short answer is “no”, paying off old debt does not hurt your credit score. It also doesn’t improve your credit score that much either. Here’s why..
Once a debt hits the 180 days past due mark, it is recorded on your credit history and carries forward as a negative mark for 7 years. Nothing you can do will remove this prior to that 7 year expiration, so in effect the damage has already been done. Paying off that debt is the responsible thing to do, but you won’t be rewarded with a higher score for doing so. It does look better to lenders that you paid it off however, no matter how long it took.
So for debts 180 days past due, it’s better to pay them than not but don’t expect a big bump in your score for doing so.
The underlying reason for this is that creditors weigh your ability to remain current with your bills more than your ability to pay them back eventually. The better way to improve your credit score is to remain current on your debt and pay your bills on time. If you’re just focusing on paying off debt and some of it is past 180 late, then start at the most recent or current debt and work your way back, paying off the 180+ days late debt last.
Here’s an accompanying video clip in which Farnoosh Torabi, Jean Chatzky and David Bach field this question and more. (feed readers may need to view the complete post to see the embedded video)
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