Posted: October 25th, 2011 | Author: Joe | Filed under: Debt | Tags: APR, APY, loans, Tips | No Comments »
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.
The heart of the problem is Compounding Interest.
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.
Further recommended reading: APR and APY: Why Your Bank Hopes You Can’t Tell The Difference
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Posted: August 9th, 2011 | Author: Joe | Filed under: Saving, Tips | Tags: Auto loans, Buying a car, Car loans, Financing, loans | No Comments »
It’s a well known “secret” that the average American cannot afford a new car . That article focuses mostly on the fact that people borrow way more than they should when buying a new car. But this post is about buying a car outright – with no financing. Very few people can afford to buy a new car without taking out a loan, but they would be better off if they could only figure out how to break the cycle of new car – new loan.
Matt Jabs shared his ideas on How to STOP Financing Your Vehicles at DebtFreeAdventure.com and it got me fired up on the topic again.
Regular readers already know that I learned a lot from my expensive mistake buying a car when I was younger. Mostly what I learned was how not to get entirely ripped off in the process. I thought at the time that it was used car salesmen that were out to rob you blind, but I learned that the new car salesmen can take a lot more without you ever really being aware of it – until it’s too late.
So, I learned what NOT to do when buying a new car. Years later, when my wife and I were expecting our 3rd baby and had to upsize our family vehicle, I put those lessons to work and shared a few more lessons I learned when buying a car.
But, if you click through to that last link you’ll notice while I didn’t get taken for a ride, I still had to take out a loan for the new car.
The truth of the matter is that getting off the financing treadmill is just not that easy.
Here are Matt’s 5 tips to stop financing your vehicles:
- Stop thinking you have to borrow money to buy a car.
- Aggressively pay down existing auto loans.
- Continue saving after the loan is paid off.
- Buy used.
- Save for repairs and maintenance.
To be honest, my wife and I did #2 and 3 above before we upsized our car… we just didn’t have enough time between paying off the previous loan and buying the new car, so we had to finance a good chunk of it. We also bought used. If it was just my car, I probably would have bought an even older car and financed less, but since it’s the family car and I would hate for my wife to break down in the middle of nowhere with 3 small children, we settled for a 2 year old vehicle. Most of the depreciation was over at that point also.
So, we’ve made progress in the process, but we’re not there yet. Hey, I said they were simple steps, not easy. 
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Posted: July 6th, 2011 | Author: Joe | Filed under: Debt | Tags: Debt, debt consolidation, loan consolidation, loans, Tips | No Comments »
What does debt consolidation mean? The term seems to have different uses among different people, but here are 3 different types of debt consolidation.
Debt consolidation loan
When most people talk about debt consolidation, they mean a debt consolidation loan. Find out more what a debt consolidation loan is here.
If, for example, you owe money on two credit cards and a loan, it may be better to take out one large loan, big enough to pay off all three debts at the same time. That would leave you with one payment to make every month instead of three.
Making one payment every month is just easier than arranging and budgeting for three separate payments – and you will only have to deal with one creditor.
You could even reduce the amount you pay every month if your loan has a longer repayment period. However, paying off your loan over a longer period could also increase how much you pay overall, due to interest.
Anyone interested in debt consolidation loans could try an online debt consolidation calculator. They help you to estimate your monthly repayments once you’ve entered a loan amount, interest rate and repayment period.
If your earnings change from month to month, or you’re not sure you’d be able to make regular repayments, you might find a different approach is more appropriate.
Balance Transfer
Another way to consolidate debts, which can work well for credit card debt, is to transfer multiple debts onto a 0% credit card. ‘Balance transfer’ cards don’t charge interest for a set period, after which time the card starts charging interest.
For that reason, a balance transfer could be ideal if you are able to clear the balance before the interest-free period ends. Otherwise, it may be possible to transfer the balance to another interest-free credit card. However, you’d normally be charged a transfer fee each time, something like 3%. For large balances, that could be quite expensive.
Other forms of debt consolidation
There are other ways of consolidating problem debts into one monthly payment without borrowing any more money. These include IVAs (Individual Voluntary Arrangements) and debt management plans.
Useful websites:
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Posted: April 11th, 2011 | Author: Joe | Filed under: Credit | Tags: Borrowing, Credit, Credit score, Debt, Guest Post, loans | No Comments »
Credit repair is a hot topic these days – largely because it is a crucial element of overall financial health. Without maintaining good credit, you are not only likely at the mercy of lenders should you ever need financing, you are also guaranteed to spend more money than a consumer who maintains a good credit record and solid credit scores.
Why Credit Should Matter Now
Many consumers make the mistake of waiting until the last moment to do something about their credit scores and only make the attempts when they need to secure financing. But waiting until the last minute these days is a measure in ‘too little, too late’. It is important to do something about your credit score now regardless of your timeline or need for financing.
Here is an overview of situations where a bad credit score will cost you big bucks:
Mortgage lenders are scrutinizing credit histories and scores harder than ever thanks to the near-meltdown of the industry a few years ago. There are now stricter lending laws being imposed and borrowers need to come to the table with really good credit in order to have the most opportunities for an affordable home loan. Those without good credit scores will have a tougher time getting lender approval and for loans that are approved the interest rate of the loan will be higher, meaning you’ll spend a lot more money over the life of the loan than if you were eligible for a lower interest rate. Your loan terms and conditions may also be stricter such as requiring more than the typical 20% down payment on your loan.
Auto Loans
Like mortgage lenders, auto loan financing may be impossible for those with bad credit or the interest rate you pay on the loan may be much higher than for other buyers. As a result, you will pay more for the vehicle over the life of the loan, which is essentially a price you can’t make up in the value of the vehicle since most vehicles depreciate as soon as you drive them off of the sales lot.
It is not just financing companies that are looking closely at credit scores. Insurance providers are pulling credit scores on customers in order to gauge their potential for claims being filed. Insurance providers use a theory that credit history is relative to claim potential, meaning that those with lower scores are more apt to file an insurance claim. If you have a low score, you will have to pay a higher premium on your auto and home insurance than consumers who have better credit backgrounds.
Utilities/Consumer Services
There are many regular service providers who will pull credit scores before approving service applications. If customers have low credit scores, most providers will require a hefty down payment or prepayment on accounts to prevent risk of the bill not getting paid. For instance, with a low credit score, you may have to put up several hundred dollars on your mobile phone account or if you open a new account with the electric company, a deposit might be necessary to start services. Such deposits are often held for up to a year to gauge prompt payments each month and only then will you receive a credit.
If you are looking to apply for a new credit card but have a poor credit score, your options will be seriously limited. In some cases, you will only be eligible for secured cards, which means you need to send several hundred dollars as a prepayment. Secured cards will also require you to keep up with timely payments to keep the account loaded and change significant fees for transactions and penalties for late payments or over-the-limit charges.
While credit repair is possible by anyone, what is important to remember is that it is a time-intensive process that should begin as soon as possible. Even if you are not anticipating a need for a loan in the near future, there are too many other resources relying on credit scores for you to ignore the importance of your credit standing. Over time and with good financial management practices, you can improve your credit score to where it should be. Today, lenders are looking for borrowers with a credit score of 730 or higher in order to afford the best deals and the most options.
This is a
guest post by Ed O’Brien. Ed is an expert writer on personal finance, specializing in
credit repair. You can find more of his articles located at
CreditRepair.org.
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