Credit and Its Cost


What is Credit?
Credit is money granted by a lender (or creditor) to a debtor (or borrower) whereby the lender defers receiving payment of the debt for a period. In exchange for the credit allowed, the lender will get back the money lent plus interest. The borrower has use of the money immediately, rather than waiting until the money required is saved up.

It enables the borrower to pay for things immediately, even if they cannot afford to pay for it themselves. Interest is the compensation required by the lender for the use of his/her money. There is a time value to money because of inflation, by way of an interest charge.

What is the Cost of Credit?
The cost, or charge, for using credit debt is called interest. This interest can either be simple interest or compound interest.

    * Simple interest
      This is interest charged only on the principal amount borrowed. Simple interest does not add interest that's due, back on to the principal amount because it is usually paid out.

    * Compound interest
      This is interest charged, not only on the principal amount owing, but also on the interest that has been accrued on that principal amount. The interest is added on to the principal and then the new interest is calculated on the new total of those two items.

What happens is that there is a compounding effect, so that interest is charged on the interest. The result is that the lender receives a higher and higher return because the interest charge is levied, not only on the amount originally lent, but also on all interest due on the amounts over the term of the loan.

APR - Interest Rate
The APR is the reference to the interest rate the lender charges the borrower for the use of the money. You need to know a little about APR because it shows what the cost of the credit actually is. The cost of credit is more than just knowing the interest rate; it is important to be familiar with the annual percentage rate.

The APR is the cost of credit measured on a yearly basis and expresses a yearly rate. By comparing the APR of loans or credit cards etc you can work out which card is likely to cost you the most. You need to find out what the correct annual percentage rate being charged to you is so you can make decisions on your lending situation because it will affect the selection of credit cards or other loans you are looking at taking on.

Using the APR to your Advantage
If you carry a balance from month to month on your credit card and the card has a high APR, the only way to reduce the interest is to pay more each month. If you only pay the minimum amount, not only will it take you a long time to reduce your debt, but you will also pay more interest.

All the time you carry a balance on the card, the interest adds up. A credit card balance can actually increase considerably when you only make the minimum payments. This is because the balance on your card is left to accrue interest over time and so it just keeps growing. Check out what the APR is because the lower your APR, the lower the fees charged to you.

What's the Difference Between a Fixed and Variable Rate?

    * Fixed - A fixed interest rate means that the rate of finance charged does not change throughout the term of the loan. For example, you may take out a loan at 5% fixed for three years. This means that the interest rate will not change over that three-year period and will remain at that 5%.

    * Variable - A variable rate, however, is determined by an index such as the prime rate charged by banks. The variable rate allows the bank to charge an interest that more correctly reflects the current market conditions.

When shopping for a loan, make sure you understand clearly the difference between a fixed and a variable rate.


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