The Role Interest Rates Play in Consumer Debt
Interest rates are a big factor when it comes to debt, especially when you’re repaying your debt. Your interest rate makes the difference in several months and several thousand dollars of debt pay off. The interest rate is a percentage charged on money you borrow.
On loans, interest is sometimes added to the loan upfront based on the interest rate, loan amount, and repayment period. In these cases, interest is built into your loan payoff. Since loans have a fixed payment amount that includes interest charges, you know upfront just how long it will take to pay back that long (as long as you make your payments on time, of course).
With credit cards, interest in the form of a finance charge is added to your balance monthly until you pay off the balance unless you pay the balance in full before the grace period expires. The higher your interest rate, the higher your finance charges will be. When you’re trying to pay off your debt, higher interest rates hurt you because much of your payment goes toward the finance charge.
The chart below visualizes a scenario in which you would have $20,000 in debt, paying $400 monthly. It explores two scenarios, in which the first APR is 10%, and the second APR is 20%.
Interest Rate Example
The finance charge on a $20,000 balance at 10% APR would be $167. With a make a payment of $400, about $233 goes toward reducing your balance; the rest is applied to the interest.
If that same balance had an APR of 20%, the finance charge would be $333. With the same $400 payment, your balance would only go down by $66! Since your balance is only decreasing by a little bit every month, it will take much longer to pay off your debt.
In the first example of $20K at 10% APR, it would take just under 5 ½ years to pay off your debt if you consistently make $400 monthly payments. However, at 20% APR, it would take you a little more than 9 years to completely pay off the balance and that’s assuming your interest rate doesn’t go up, you don’t make any additional charges or have any fees added, and you continue to make the same monthly payment each month.
How Much Interest Do You Ultimately Pay
In the first example, you’ll pay $5,980 in interest by the time you pay off the balance. In the second example, at 20% interest rate, you would pay significantly more - $23,360!
The only way to save money on interest is to significantly increase your monthly payment – to $820 per month – or to get your credit card issuer to lower your interest rate. The bright side of the increased payment is that you could pay off the balance in less than three years with that payment, even with the higher interest rate.
Getting a Lower Interest Rate
Convincing your credit card issuers to reduce your interest rate isn’t always easy, especially if you don’t have the credit history to qualify for a lower interest rate elsewhere. But there’s some good news: if your interest rate increased because you were 60 days late on a credit card payment, the credit card issuer has to lower your rate after six consecutive timely payments. Even if you’re less than hopeful about getting your interest rate increased, it’s worth a try. And if your credit card issuer turns you down this time, try again in about six months.