There are 3 key factors that we need to understand when going "into debt":
Principal: The original amount of a debt on which interest is calculated.
Interest: A fee paid on borrowed assets. It is the price paid for the use of borrowed money. An interest rate is the rate at which interest is paid by the borrower for the use of money they borrow from a lender. Interest rates are normally expressed as a percentage rate over a period of one year or APR.
Term: Time over which a loan or debt is paid. The term of the loan may be as little as a few months and as long as 30 years. In the case of credit cards there is no fixed term.....more on that when we talk about credit cards (in detail).
So in human terms.
The amount you borrow or put on a credit card is the principal.
For example:
- If you buy a new blouse using your credit card; and it costs $25, then the principal added to your credit card bill is $25.
- If you buy a new car. The car costs $10,000. Yo pay $1,000 cash and borrow $9,000. The principal for that car loan is $9,000.
Now there's interest.....interest is what the credit card, bank or finance company charges you for borrowing the money. Remember when you buy a sweater with a credit card, you are essentially borrowing the money to buy that sweater. Companies and banks don't let you borrow money because you are nice....they are in the business of making money so they charge a fee on what the lend you, that is how they make money...that fee is called interest.
So what's the low down on interest.....how do they calculate it, how do they determine what to charge as interest, how does it work.....(my next post will be on credit cards, charges, fees, etc).....for now...let's keep it simple.
Your bank credit card says all purchases are charged and APR (annual percentage rate) of let's say 12%. What does this mean.....it means you pay 12% on your purchases on an annual basis...so let's do the math...
You buy a sweater on Jan 1st. for $100, using your credit card (12% APR), so let's say you haven't paid a dime on that bill by Dec. 31st you would owe the credit card company $112 right? Well, that is the simple interest way of calculating interest. You would also think that if you paid off that sweater little by little you would owe have paid the company less than $12, right? Let's do the math....
Normally, what credit card companies do, is that they calculate the APR on monthly balances, and they will calculate the interest on the total balance due, not just the principal outstanding....
Check it out:
What happened? Why is the interest total after a year $12.68 instead of $12.00? On a monthly basis, the interest calculation is based on monthly balance, so the interest rate divided by 12 (12 months) then calculated on the total balance principal outstanding plus interest on a monthly basis. This is usually referred to as monthly compounding. Can you imagine what or how much interest would be charged if this was compounded daily? Let's see:
Yikes, $0.75....this is using a daily compound rate.
So I know what you are saying, what gives, who cares, it is only 68 cents or 75 cents who cares?....well think about it, this is on $100 with a $12% APR, most credit cards charge around 20% APR, and most people purchase more than $100....so yes it does add up, and creeps up on you before you know it.
