“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” ~ Albert Einstein.
I love that quote, but getting by without paying any interest at all is simply not realistic anymore, especially in 2019. Usually, in order to build wealth and accomplish our dreams, debt (and interest) are unavoidable. But that doesn’t mean you have to pay more interest than you should.
This is why it’s important to know what the desired interest rates are so you can know when you’re paying too much.
How Do Interest Rates Work for Consumers?
The interest rate you qualify for at a bank is largely dependent on your credit score, which is a score that tells lenders how likely you are to default on any type of loan. The lower your score, the riskier of an investment you are to a bank. Got perfect credit? It’s because the FICO algorithm thinks you’d be less likely to ever default on a loan. To dive deeper into what makes up your total credit score, click here.
The Federal Reserve sets a ‘prime rate’, and then banks tack on a little bit extra interest on top of that so they can make money.
This means the ranges for interest rates can change, depending upon where the government sets the primate rate.
So How Much Interest is Too Much?
In 2019, you’ll want to aim to keep your interest rates within these ranges.
- Car loans: Look for interest rates between 4.70-5.20%. (via Bankrate)
- Credit cards: This is where interest rates can get a little scary. Those with excellent credit can expect an average purchase APR around 14.5%, good credit scores can expect an average APR of 20% and fair credit consumers can expect an average APR of 22.5%.
- Mortgages: Currently interest rates are averaging around 3.875% (via Wells Fargo)
Again, these rates could change on a daily basis, so if you’re about to start shopping for a loan, Google current interest rates or check out Bankrate.com for up to date information.
What Do I Do If My Interest Rates Are Too High?
If you’re looking to lower your interest rates, first work on improving your credit score. I like to remind people, “the lowest interest rates require the most excellent credit.”
Have a higher interest rate on a loan but above-average credit? It may be worth it to explore refinancing options so you can start paying the debt at a lower interest rate.
If refinancing isn’t an option, remember that paying down balances is also a way to save money on interest (and also improve your credit score at the same time!) The less you owe, the smaller the amount of interest paid over time becomes. Additionally, paying off balances lowers your debt-to-income ratio, which directly impacts your credit score.
How Much Debt Is Too Much?
But the question of “how much interest is too much” isn’t really the one you need to be asking. If you’re taking on debt, interest is unavoidable. It’s simply the cost of doing business unless you happen to take on 0 interest debt from a friend or family member.
Really, the question you need to be asking is “how much debt is too much?”
- What the banks say: Ideally, you’ll keep your debt-to-income ratio below 30%
- What financial experts say: Debt is bad. Have zero debt. Buy everything in cash if you can.
- What’s realistic: Somewhere in between what experts say is ideal and what banks allow.
Remember: banks make money when you borrow, so it is in their interest to get you to borrow as much as possible.
It’s important to only take on as much debt as you can reasonably afford while still making contributions to retirement, your emergency fund, and long term savings. This means after paying your living expenses and all debt payments (student loan, car, credit cards, house etc.) you should still have some leftover.
How Can I Pay Less in Interest?
My best tip for paying less in interest is simple: think twice before you finance something like tires, furniture, clothes at checkout or beauty treatments.
My husband has a saying, “If we have to finance it, we can’t afford it.” Quite often, this drives me bananas because it means we have to wait forever to make a purchase. It also really hurts to see your money leave your bank account all at once.
I will admit, however, it’s saved us a ton of money and ensures sure we always have more money set aside for true emergencies. (Hope you’re reading this, honey!)
Research from The Simple Dollar finds the average American spends over $8,000 a year in interest alone. This is about 14% of the median household income, but especially terrifying if you look at $8,000 each year over a lifetime. That’s close to $300,000, which, in a nutshell, is a retirement nest egg or the equivalent of sending three children to college.
When looking to finance large purchases like homes, cars, or education getting the lowest interest rate possible should be your top priority. After all, it could be the difference between money leftover to build real wealth and living that #paychecktopaycheck life.