Managing interest rates If you borrow money, you pay an interest rate on your loan. The interest rate is stated as a yearly percentage rate, which is the interest cost of borrowing for one year. For example, if you borrow $10,000 at 10%, your interest cost for one year is $1,000 ($10,000*.10). This interest rate is called the simple interest rate.
The periodic interest rate is calculated in a similar way. This is the interest rate that you pay for a period shorter than one year. For example, if you borrow the same $10,000 for one month, your interest cost is one-twelfth (1/12) of 10%.
To calculate your periodic interest rate, divide the annual interest rate by the number of periods. If the period is months, divide 10% by 12 to get 0.83%. The monthly interest cost of the $10,000 loan is $83.33 [($10,000)*(.10)*(1/12)]. If you are saving instead of borrowing, the same interest rate calculations apply. Instead of paying interest, however, you earn interest income. The compounded interest rate assumes you "earn interest on interest." As a result of compounding, as a borrower, you pay an interest rate that is higher than the simple interest rate. Alternatively, you earn a higher rate as an investor than the simple interest rate, when you are receiving compound interest. In the case of tax-deferred annuities, you are receiving triple compounding, you earn interest on your principal, you earn interest on your interest, and you earn interest on the money you would have paid in taxes. The following table shows monthly compounded interest on a $10,000 loan at a 10% annual interest rate. (Compounded monthly, the periodic interest rate is 0.83%): | Periodic interest rate | Number of months | Compounded interest | Effective interest rate | | 0.83% | 1 | $83.33 | 10.47% | | 0.83% | 6 | $510.53 | 10.47% | | 0.83% | 12 | $1,047.13 | 10.47% | | 0.83% | 24 | $2,203.91 | 10.47% | | 0.83% | 60 | $6,453.09 | 10.47% | | As the table shows, compounded interest grows faster than the simple interest rate for all periods. However, the compounded interest rate remains at 10.47%. This is because you are compounding on a monthly basis. If you increase the compounding frequency to a daily basis (assuming a year is 365 days), your compounded interest rate would increase to 10.52%.
The compounded interest rate is the real rate of interest you earn as an investor or pay as a borrower. It is also called the effective interest rate. If you are a borrower, the effective interest rate is also called the annual percentage rate (APR). If you are an investor, the effective interest rate is also called the annual percentage yield (APY).
The APR includes any closing costs you pay on a loan. For example, if you borrow $10,000 and pay $500 in closing costs, you effectively borrow $9,500. (This assumes you pay your closing costs at closing instead of financing them by adding them to the loan amount.) Closing costs increase your loan interest rate. The following table shows the APR for a range of closing costs. Loan terms are a one-year loan at 10% simple interest: | Simple interest rate | Number of months | Closing costs | APR | | 10% | 12 | $100 | 11.11% | | 10% | 12 | $250 | 12.82% | | 10% | 12 | $500 | 15.79% | | 10% | 12 | $1,000 | 22.22% | | As the table shows, APR rises sharply as closing costs increase. The rate more than doubles to 22.2% when closing costs are $1,000. This should make some sense: Since $1,000 is 10% of $10,000, and you are paying an interest rate of 10%, the two rates added together equal about 20%.
You should always ask a lender to show you the APR. After all, it is your true cost of borrowing. In fact, consumer protection laws require the lender to show you the APR. If the lender is unwilling, you should apply elsewhere for a loan.
Deciding when to borrow, invest, or refinance a loan depends on the level of interest rates. Over years, interest rates rise and fall in the pattern of a cycle that is consistent with the rise and fall in the overall economy. When the economy is expanding, demand for loans is high. High loan demand leads to higher interest rates. When the economy slows down or contracts, the demand for loans is low. A slowdown in the economy usually leads to lower interest rates, encouraging borrowers to refinance existing debt.
The Federal Reserve plays a central role in determining future interest rates. The Federal Reserve, or Fed, is the U.S. Central Bank. It is responsible for setting monetary policy in the U.S. The Fed's main policy-making committee, the Federal Open Market Committee (FOMC), meets about every six weeks to evaluate key indicators of the economy's health. If it anticipates a slowdown, it may cut the fed funds, discount rate, or both. If the Fed anticipates inflation, or too much growth, it may raise rates. From June 2004 through August 2007, the Fed raised the fed funds rate 17 times to 5.25% in order to slow down the economy. From September 2007 through November 2007 rates have been reduced again to 4.25%.
Keeping an eye on interest rates helps you to decide when to borrow, and when to invest. When interest rates are heading lower, it may be a good time to borrow. On the other hand, if rates are rising, you can earn a higher rate of return by investing in money market accounts, money market mutual funds or CDs. All of these savings instruments earn a higher rate of return when interest rates are rising.
Savvy investors and borrowers aim to keep the effective interest rate on their borrowings lower than the effective interest rate earned on their investments. Given a chance to repay debt, a savvy borrower chooses to pay down or pay off the high-interest debt first.
Finally, you can take advantage of fixed-rate loans and investments to hedge against adverse movement in interest rates. For example, if you think rates may rise, a fixed-rate loan locks in your interest rate. On the other hand, if you think rates will fall, a variable-rate loan such as an adjustable-rate mortgage (ARM) will lower your loan payments as interest rates fall. For all of these reasons, managing interest rates may help you to improve your personal cash flow.
Investing or paying off debt If you receive a windfall of cash such as a tax refund or sale of a home, you may face a common dilemma: invest, pay off debt, or spend. If better personal budgeting has helped you save an additional amount every month, a debt repayment plan may be preferable to saving until most of the debt is gone.
In another topic, Managing Interest Rates, we explained that savvy borrowers and investors benefit by knowing the effective interest rates on their borrowings and investments. The effective interest rate is the true cost of borrowing or saving, adjusted for closing costs, fees, and taxes.
Generally, paying off or paying down a debt that has a higher interest rate is preferable to making an investment that earns a lower interest rate or rate of return. To make a fair comparison, you need to calculate the after-tax interest rate on your debt and investments. If your investment is not held in an interest-earning account (such as a money market or savings account, CD, or money market mutual fund), calculate the investment's after-tax return.
If you are paying off a credit card or auto loan, you can use the APR as the effective interest rate, or use the stated interest rate, for sake of simplicity. If you are paying off a mortgage, home equity loan, or student loan, start by subtracting your income tax bracket from 1.0.
For example, if you are in the 25% tax bracket for 2008, you would have 0.75 (1.0-0.25). Then, multiply 0.75 by the loan interest rate. The result is your after-tax interest rate on tax-deductible debt. If you have a mortgage loan of 8% and are in the 25% tax bracket, your after-tax interest rate is 6%.
You should calculate the after-tax interest rate or return for investments held in taxable accounts. For example, if a taxable investment earns a 10% return and you are in the 25% tax bracket, your after-tax return is 7.5%. In most cases, the APR on your credit card debt or an auto loan is higher than the after-tax interest rate or after-tax return on an investment. These types of consumer debts, particularly credit card debt (since it is unsecured credit), are among the most expensive. As a result, paying off a credit card is almost always a better deal than investing. While some investors use their credit cards to raise funds for speculative investing, this kind of leveraging is an extremely risky practice and should be avoided. Paying off debt is sometimes a painful experience. Not only do you miss a chance to spend, you also pass opportunities to save or invest. However, if you've improved your budgeting efforts and have been able to save extra money, you will improve your personal cash flow further by paying off high-interest debt. The basic relationship - pay off debt that has a higher interest rate than what you earn on your investments - is a practical step in the right direction.
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