While there are many habits you want to stop if you want to save money, paying less on interest is, for many of us, the main one. These days it is far too easy to get credit and buy things and pay them off over time. While there are times this has to be done, most of it is just a waste of money.
We have discussed good debt and bad debt. While a home loan or loan for education is generally good debt, buying clothing, furniture, and even groceries and food is bad debt.
Understanding interest
What is interest?
Interest is the fee a company charges you for buying something on credit. If you pay cash, you do not pay interest. If you pay the item off over time the seller will charge interest. The same applies to banks. If you take a loan, use a credit card, or have an overdraft, the bank, or lender will charge interest.
While this is fair as they do not get the money immediately and take on a certain amount of risk, credit can be very expensive.
Fixed and variable interest rates
The standard interest rate is determined by the main (central) bank of each country. It is sometimes known as the benchmark interest rate, the repo rate, or the prime rate. It is the rate at which the central bank lends money to the top commercial banks.
When you buy something on credit you either get a fixed interest rate or a variable interest rate. If it is fixed it remains at the same rate until you have paid off the debt. A variable interest rate will go up and down as the prime rate changes.
At the moment, in 2021, interest rates are generally very low. This is no guarantee that they will remain that way for very long.
Short-term loans or credit normally come with a fixed interest rate while longer loans, such as home loans and often vehicle finance, often offer you a choice between fixed or variable interest. Many credit cards also work on a variable interest rate.
If you choose a fixed interest rate you will pay slightly more interest but will not have to pay more if the rate goes up. You will also not benefit if the rate comes down.
With variable interest, your monthly payment could go up and down according to the prime rate. You will sometimes win and sometimes lose. It depends on local and world economics, among other factors.
It is easier to budget with a fixed interest rate as you know what you will have to pay every month and will not be in for a shock if the interest rates suddenly start to climb. This has happened several times in the past and many people got into financial trouble as their repayments were more than they could afford.
There is no perfect answer but a fixed interest rate, if you have a choice, is a safer bet.
How is interest calculated?
Again, this will depend on the type of loan. It is generally calculated on the daily balance of the debt. You also have to remember that interest on debt, as it does with savings, is compounded. This means that you pay debt on debt. It is often known as the difference between the nominal rate (the one they show you) and the effective rate (what you actually end up paying).
You will pay interest on the interest that has been added to your debt. It sounds complicated but it simply means that the longer you stay in debt, the more interest you will pay.
This is also why it often makes sense to pay debt off as quickly as possible, pay a bit more every month, or pay more than once a month if you can. Even paying your bond a few days earlier in the month, if you can, will save you a lot of money over time.
Is the interest rate the same on all credit?
No, not at all. Some types of credit are much higher than others.
Generally, a secured loan such as a bond has a relatively low interest rate. These loans are backed by the property or items the lender can take back if you fail to pay.
Interest on vehicle finance ( a car loan) is a bit higher. Unsecured loans such as personal loans and credit cards tend to be much higher.
Stores offer a range of credit options with some offering limited credit free periods if you pay the debt in a certain time.
Buying furniture, taking personal loans from smaller companies (micro loans) and “payday” loans often charge a large amount of interest. They also add in other charges, more on that below.
When taking any type of loan or signing a credit agreement it is important that you understand exactly what you will be paying.
Are the other costs apart from interest?
Yes, there are. Interest is only one cost you need to worry about. There are many other charges in some cases.
- Initiation or admin fees – This is a fee that many places charge to arrange the loan or the finance. It is a charge that is added onto the original “cash” amount of the item or the loan that you get. You will pay interest on this amount along with the rest of the debt.
Even something as simple as a delivery fee needs to be thought about. The amount might seem small but if you pay it off over time, with interest, it will be a lot more.
- Credit life – This covers you if you should die while the loan is in effect. While you do not want to burden your family with debt if you do pass away, look at this charge carefully.
In some cases, you have to have life cover but not necessarily from the lender. If you have enough life cover already, to cover your debt and leave some for your loved ones, you might not want or need this extra expense.
- Unemployment protection – Again, this is a good idea in theory but be careful. Often the conditions are restrictive and it is very hard to claim It can also be very expensive.
It might be better to put some savings aside in case you lose your job.
- Early cancellation fees – If you are in a position to pay the debt off before you have to, many places charge you a fee. You need to understand these and be aware of them.
- Club fees and other charges – While this has become heavily regulated in most places, many companies love to add a club fee or some other charge to your monthly account. They might talk you into it or you simply sign and agree to it without knowing you have done so.
Watch out for these charges. They generally offer very little benefit and the monthly charges add up. Again, if it is a debt, you will pay interest on these charges.
How to avoid paying interest
Although not always possible, the only way to not pay interest, in most cases, is to pay cash. Rather save up for things you want and only buy what you can afford. Living under debt is expensive and will lead to stress. Rather make a short-term sacrifice, put money away, and buy what you need when you have the money.
This might never be possible with a house, a car, or student costs, but avoid all unnecessary debt and the interest that goes with it. You will get so much more value out of your money if you do it this way.
How to prevent paying too much interest
The first step is to look carefully at the offer. That item of furniture you think you need right now might sound affordable when you look at the monthly payments but you could end up pay double even triple the price.
Look closely at the agreement and makes sure you understand the total cost including all the extras and especially the interest. Read the fine print.
Pay every month. Missing even one month will add you your debt and possibly result in penalties.
Be careful about any extras added to your account.
Shop around. Not all places charge the same interest so it is important to shop around if you are looking for a loan, credit card, or other forms of credit. Some places are quite generous while others will take advantage.
Use your bond or credit card at the right time. Ok, so we say do not get into more debt but if you really need something essential it might make sense to use your bond or your credit card. This is often less expensive than other forms of credit.
You have to look at the total cost, not just the monthly cost. In other words, do not use your home loan to buy a car and pay it off over 20 years. Use it, if you must, but pay it off quickly.
Do not take on more debt. As you work to reduce your debt, avoid the temptation to take on more debt. This is a mistake many people make when they feel a bit of false financial freedom.
Focus on the most expensive debt first. As we said before, not all debt costs the same. It makes more sense to pay off the debts with the highest interest rates faster than those with a lower rate.
Final thoughts
Bad debt and interest costs need to be avoided. If you already have bad debt you need to make an effort to pay it off as quickly as possible. This will give you more money every month and is the only way to financial freedom.