Series: General Concepts

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Pay Attention to Paying Interest Terms of Use:

Let’s say you let your neighbor borrow your lawnmower for a week, but you tell him that at the end of that week, he'll have to return the lawnmower and pay you $10. That is how interest works when you borrow money.

You have to pay a certain amount of money to "rent" money for a certain length of time. Both the lender and the borrower agree on the amount of interest before any money is "rented."

In the Middle Ages, nearly everyone in Europe belonged to the Roman Catholic Church. Just as today it would not be considered neighborly to charge a friend to borrow your lawnmower, back then the Church taught that God wanted you to freely loan money to friends to help them out. The thinking was also that the lender had too much advantage over the borrower, who stood to lose his collateral if he didn’t pay his loan.

Usury laws outlawing any interest payments whatsoever were passed throughout Europe. It was only after the Protestant Reformation in 1550 that usury laws were changed so that a small amount of interest was okay to charge.

Since each state can set its own usury level, there are many different state and national usury laws in our country today.

In parts of the world where the Islamic religion dominates, it is still illegal to charge any interest based on religious reasons similar to those of the Middle Ages.

Most interest is a certain percent of the principal (the total amount loaned) collected over a set period of time. For example, if you borrow $100 at 5% simple interest, at the end of the first year, you will owe $105 ($100 x .05). If you borrow $500 at 5% simple annual interest, you will owe $525 ($500 x .05), etc.

A loan can be secured by collateral or it can be an unsecured loan.  If you borrow money to buy property (which is also called taking out a mortgage), the house or land is collateral on the mortgage or loan. Your financial institution has the right to sell your property and keep the money if you default on your mortgage (you fail to pay according to the terms of the loan).

In the same way, a car is collateral or security on a car loan. Sometimes if you use a store credit card, the thing you buy can be collateral. The store has the right to repossess it (take it back) if you default on your credit card. Other secured loans include home equity, agricultural, and vehicle, boat or RV loans.

Series: General Concepts

Page 2 of 2

Pay Attention to Paying Interest Terms of Use:

Unsecured loans are often from relatives, friends, employers, or credit card companies. Examples of unsecured loans are credit cards and personal loans for debt consolidation, vacations, education and other things.

Credit unions, banks and thrifts offer different kinds of loans with varying interest rates. The government also offers unsecured loans for college. If you default on them, the lender can collect his money through our court system.

All financial institutions charge interest on the money they loan, and pay out interest to people who keep money in their accounts. Of course, in order to stay in business, they have to charge higher interest on the money they loan out than on the interest they pay for deposits.

Since credit unions are not-for-profit, their interest rates on loans are sometimes lower, and any profit is often returned to their members in the form of higher dividends on savings or lower loan rates and low cost services.

Common sense tells you that when borrowing money for any purpose, you’ll want the lowest interest rate. Remember to include the fees charged you (also called finance charges) and any closing costs to figure the true cost of a loan.

When borrowing money to purchase a home, you may want to decide between paying “points” (a lump sum upfront) to get a lower rate of interest. Each point costs 1% of the mortgage amount, so the more points you pay, the lower your rate.

To decide, you need to consider whether you can afford to pay for points now and the length of time you expect to have the mortgage.

The longer you plan to keep your mortgage, the more it makes sense to pay for points now because you’ll have a long time to benefit from the lower rate. Financial calculators can help you decide. (See below).

What about zero-interest offers on car financing, home furnishings, appliances, electronics and credit cards? Before you get too giddy and sign on the bottom line, be sure to negotiate the best deal on the purchase price of your new car or truck (for example). Otherwise, you’re zero-interest financing a higher price!

On credit cards, be sure to check whether zero percent interest is on balance transfers, purchases or both. Check the fees, too. While zero percent interest is enticing, there may be a hefty price to pay for each balance transfer.

Oh, and be sure to pay on time or you may find the zero percent interest deal pulled out from under you (and your new rug!) and replaced with a higher interest rate and late fees.

Bottom line: borrowing is easy – paying back the loans is not so easy, especially when you pay considerably more than you originally borrowed, thanks to interest.

See what you learned.

Check out "Very Interest-ing" and "Better Than A Mattress"