APR, APY and the fine print
Two abbreviations do most of the work. APR, the annual percentage rate, is the yearly cost of borrowing, and on mortgages it folds in certain fees so that offers can be compared. APY, the annual percentage yield, is what a deposit earns in a year with compounding included. A rate may be fixed for the life of the loan or variable, meaning tied to a benchmark that moves when the Federal Reserve raises or lowers its target. Nearly all credit cards are variable, as are savings accounts. Most auto loans, federal student loans and ordinary mortgages are fixed.
How a credit card charges you
A card divides its APR by 365 and applies that daily rate to your balance every day. At 24 percent, that is about 0.066 percent a day, and a $3,000 balance costs about $60 a month in interest alone, so a minimum payment of $90 puts only $30 toward what you owe. Pay the statement balance in full each month and the rate never applies to you at all.
How a loan charges you
Car loans, student loans and mortgages are amortized. The payment stays the same every month, but early payments are mostly interest, because interest is charged on a large remaining balance. An extra payment in the first years of a loan therefore saves far more than the same payment near the end. If you pay extra, tell the lender to apply the money to principal, or it may simply be treated as an early payment of next month's bill.
The rule of 72
Divide 72 by an interest rate and you get the approximate number of years for money to double. Savings at 4 percent double in about eighteen years. An investment averaging 7 percent doubles in about ten. A card balance at 24 percent, left alone, doubles in three. The rule explains the usual order of operations, which is to pay off anything charging more than you could plausibly earn before you invest.
What sets your rate
Your credit score, the loan's length and any collateral all move the rate you are offered. A shorter term usually carries a lower rate and always costs less in total interest. When comparing two loans, compare the APR and the total cost over the full term, because a lower monthly payment stretched over more years is frequently the more expensive loan.
Tip Before signing any loan, ask whether there is a prepayment penalty. Most consumer loans have none, and that lets you pay ahead whenever you have spare cash.
