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Understanding IR

Paying Interest

When you borrow money, you generally have to pay interest. But that might not be obvious – there’s not always a line-item transaction or separate bill for interest costs.

Installment debt: With loans like standard home,1 auto,5 and student loans,6 the interest costs are baked into your monthly payment. Each month, a portion of your payment goes towards reducing your debt, but another portion is your interest cost. With those loans, you pay down your debt over a specific time period (a 15-year mortgage or 5-year auto loan, for example). To understand how these loans work, read about loan amortization.

Revolving debt: Other loans are revolving loans, meaning you can borrow more month after month and make periodic payments on the debt.7 For example, credit cards allow you to spend repeatedly as long as you stay below your credit limit. Interest calculations vary, but it’s not too hard to figure out how interest is charged and how your payments work.

Additional costs: Loans are often quoted with an annual percentage rate (APR). This number tells you how much you pay per year and may include additional costs above and beyond the interest charges. Your pure interest cost is the interest “rate” (not the APR). With some loans, you pay closing costs or finance costs, which are technically not interest costs that come from the amount of your loan and your interest rate.8 It would be useful to find out the difference between an interest rate and an APR. For comparison purposes, an APR is usually a better tool.

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