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price tag. Fees and charges are like “extras” that drive up the total cost of a loan. The difference between the interest rate and the APR is illustrated below. Let’s check it out:
Compare Credit by
Loan A
Loan B
If a borrower compared Loan A and Loan B by interest rate only, Loan B looks like the cheaper option. The APR factors in costs and fees, which shows that Loan B is a far more expensive product.
Interest Rate
Principal Interest 5% Cost of Loan Principal Interest 5% Origination Fee Annual Fees True Cost of Loan
$100 $5 $105 $100 $5
Principal Interest 4% Cost of Loan Principal Interest 4% Origination Fee Annual Fee True Cost of Loan
$100 $4 $104 $100 $4
Annual Percentage Rate (APR)
$0 $0 $105 = APR 5%
$2 $2 $108 = APR 8%
Credit is a Product. Think of credit as a product . You can shop around and compare prices and deals just like you would if you were buying shoes or new laptop. When shopping for credit, compare products by the APR, not just by the interest rate to know which is the better deal. Keep in mind that there can be other potential charges too, such as late-payment fees, charges for exceeding your credit limit, and transaction fees . The APR does not reflect these costs because they are contingent upon the borrower’s actions. Reflect on Learning: Can you list the downsides of credit? Debt, potential overspending, and the cost. Can you explain the difference between an interest rate and APR? V. Using Good Debt to Build Wealth Why is a lesson about debt included in a unit about building wealth? As historical benefits of credit prove, debt has a role in building wealth. However, for a consumer like you, there is bad debt and good debt . Generally, “bad” debt is credit card debt incurred for such things as too many restaurant meals, the newest electronic gadgets, and trips to the mall. Consumer debt is considered bad debt because the things purchased will not increase in value. In fact, over time, they will lose value. “Good” debt is non-consumer debt incurred for the purpose of acquiring things that may increase in value over time and build wealth over time . In your life, there are three kinds of good debt you are likely to experience. Let’s explore those! Student Debt. A college education is an investment because it adds value to a person by improving their skills and earning capacity. Investment in education is so important to personal wealth building and to the nation’s economy that the federal government encourages it by subsidizing or guaranteeing loans to students . Most students must borrow money to pay for college. In fact, according to the Institute of Education Sciences, about 85-90% of undergraduate students at 4-year degree-granting institutions receive financial aid. Generally, student debt is considered good debt. However, it is important to see a college education all the way through to a degree. If you drop out, you will have taken on the burden of debt, but forfeited the benefits. High Cost of Higher Ed In 2015, the average American college graduate had $35,000 in student loan debt. Fin Lit Trivia Fin Lit Trivia Fin Lit Trivia PRODUCT PREVIEW
Chapter 7 | The Credit Conundrum 120
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