If you just put another Uber fare on your credit card, bought a new set of wheels with auto finance, or took out a personal loan to pay for that trip to Vegas, chances are you’ll pay interest.
If you’re not sure how interest works, or what it really ends up costing you each year, we break it down so you don’t fork out more than what you expect and over what could be a longer period of time.
What is interest and how does it work?
When you pay for things on credit, you’ll often pay back more than what you initially borrowed. This is because your lender will generally require you to repay the loan amount, with interest on top.
Typically, interest will be charged as a percentage of the total amount borrowed. For example, if you’re loaned $10,000 at an interest rate of 10% per annum, you’ll have to pay an additional $1,000 in interest charges at the end of 12 months, meaning the total bill ends up being $11,000.
As you reduce your loan amount, your interest repayments will also come down, but you should remember that in order to reduce your loan amount, you’ll need to pay off the interest owing—and a bit extra—or your loan amount will remain the same.
For instance, sticking to the above example, if you only cover your interest charges and don’t reduce your loan amount over five years – you’ll have paid $5,000 in interest and still owe $10,000 on your loan, taking the total bill to $15,000, which could be even higher if you don’t cover the interest in full.
Note, interest-free periods may apply (something that's often the case with credit cards), which means you may be able to avoid paying interest in some instances, but only if you repay what you owe in full before the interest-free period ends.
How to reduce what you pay in interest and added fees
- Only apply for credit you need and can repay.
- Pay your debts on time to avoid additional charges.
- Consider setting up alerts or direct debit payments as this can help you to stay on schedule.
- When it comes to credit or store cards, try to pay the full amount rather than the minimum owing, or you’ll still incur interest on the balance that’s leftover.
- Look at whether you can afford (and if your lender allows you) to make extra repayments as you may be able to pay off what you owe faster and reduce what you pay in interest.
- Shop around for providers with lower interest rates and no annual fee, as this can make a big difference to what you pay back on top of the principal amount. There are comparison sites, such as Compare the Market, Canstar and Mozo, that can do the legwork for you.
- Tell your credit provider if you’re having money troubles and find out what the options are. You may be able to seek assistance by claiming financial hardship.
- Consider rolling debts into one consolidated loan if it means you can get a lower interest rate.
- Close unused credit and borrowing facilities as they may continue to charge fees.
Other things to be mindful of
Whether it’s a credit card, personal loan or car finance deal, different interest rates and conditions will apply depending on the lender, so it’s worth doing your research and shopping around.
Remember, even a small difference in interest rates could mean a big difference down the track. For instance, paying an annual interest rate of 8% versus 12% on $10,000 means you’ll fork out $800 versus $1,200 in interest at the end of the year.
Another thing that could impact the interest you’re charged is your credit rating, which is an assessment of your credit worthiness by reporting agencies like Veda, Dun & Bradstreet, and Experian.
Your general repayment history, compiled by these groups, remains on file for two years and certain black marks may be recorded for anywhere from two to seven years. If you’re interested to know what your credit report says, you’re entitled to a free copy from these agencies once a year.
Where to go for more information
- Check out common money mistakes people in their 20s make
- Get further tips on how to control debt
- See the pros and cons of rolling your debts into one
- Find out why your credit report could affect your ability to borrow
- See how you can save money without spoiling your social life.
Remember, at the end of the day it's often not how much money you earn that matters, but rather what you do with it and how well you manage it that makes a difference to what you’ll pay.
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