Many people are paying hundreds or thousands of dollars more than their original loan amounts because of interest. Unfortunately, many of those people accept interest as the cost of borrowing and using another person’s money. If all of those borrowers understood how interest works, they could be making money rather than paying more and more to lenders.
Understand What Interest Is and How It Works
The first step to reversing this cycle is understanding what interest is and how it works. Lenders calculate a percentage of the money they loan. The borrower pays that percentage, in addition to an amount of the principal, each month. However, sometimes the interest amount is high enough that monthly payments only go toward the interest amount. This means the principal amount of debt isn’t getting lower. The borrower continues to make payments on a consistent loan amount.
Lenders aren’t necessarily trying to trick borrowers out of their money. Interest is often charged as a guarantee that borrowers will pay the loan amount back. You can think of interest as a way to compensate the lender for making some money available. There are three main factors involved when determining how much interest you’ll pay:
- The interest rate associated with the loan
- The amount of the loan principal
- How long it takes you to repay the loan
You can save a lot of money by paying more than the minimum payment on your debts each time you make a payment.
Make Extra Payments
You can also make a lot of progress toward paying off the principal and the interest when you make biweekly loan payments. Here’s an example of how this works on your mortgage: Your lender probably set up your loan with 12 mortgage payments over a year. If you cut that payment in half and pay every two weeks instead, you’ll end up making an additional payment. However, you will also “trick the system” into letting you pay some of the principal.
Avoid Paying Interest
In some situations, you may avoid paying interest at all. Take a look at your credit card debt. If you limited your spending to what you could pay off in total each month, you wouldn’t end up paying more because of interest. You’ll actually increase the amount of money you’re eligible to borrow, and this will improve your credit score.
If you’re not quite ready to pay off the entire loan, research a zero-interest balance transfer. You can move the balances that are building up interest (that you’ll eventually have to repay) to a loan without interest. Be careful when researching these lenders; some are more reputable than others. Ask about the payoff terms, so you don’t end up paying all that interest or any fees for paying the loan off early.
Understand Financial Terms
Research terms that bankers, lenders, and financial experts use. The more you know about these financial terms, the better you’ll be prepared to make wise decisions about your money:
- Amortization
- Annual equivalent rate
- Asset
- Capital gains
- Compound interest
- Compounding frequency
- Credit report
- FICO score
- Simple interest
As you come to understand these terms and how each affects your finances, you may learn more about how to avoid paying interest and how to start earning interest. You can start by requesting a credit check and learning to understand everything listed on your credit report.
Learn How To Invest
There are some great ways for beginners to start investing. You may already have some savings in a bank account or a couple of CDs. You may have dipped your toes into stocks and bonds. Your next step may involve purchasing some real estate. Your home is a good asset once you’ve paid off the mortgage and built up some equity. If you can handle some extra work, you may want to look into owning rental properties.
One of the best ways to make interest work for you is through passive income. Check out fixed annuities, residual and royalty income sources, rental units, mortgage refinancing, and reverse mortgages. Just be sure to thoroughly research the pros and cons of each of these options.
Ultimately, the more you know about how loans, interest, and investing work, the better you can plan for and improve your financial future. Get rid of your debts, put money into savings, and then invest, so that interest is a way to earn money rather than spending it.
