Review and Reduce the Interest You Pay

Why does a ? percent rate cut from the Federal Reserve Bank make national news and send stocks soaring upwards?

While some answers might involve long discussions of monetary policy and macro or microeconomics, the real answer is much simpler -- and one that's pertinent to every household: by spending less on the interest payments from the money they borrow, banks and large corporations have more money to loan or spend to grow their businesses and generate larger profits.

Similarly, if people spent just a little more effort to reduce the interest they pay on purchases, they would have a lot more money to spend on the things that matter most -- such as savings, investments, travel, or other non-debt-related purchases.

According to www.indexcreditcards.com, the average consumer credit rate for a new credit card is 14.21 percent. And half of all credit cards have interest rates above that. Most Americans wouldn't buy a home or a car with a 14.21 percent interest rate, so why does this amount seem more palatable when buying a new outfit or going on vacation?

Interestingly, too many consumers consider the available balance on their credit cards as money that's just waiting to be spent. Most carry recurring balances on their accounts, while even more treat credit card payments like the monthly cable or telephone bill, making only minimum payments and ignoring the devastating effects of escalating interest charges. This is despite the fact that credit card interest rates are some of the highest interest rates charged to anyone for anything.

Ignoring interest rates on credit cards, as well as other large debts, such as mortgages and automobile payments, is a sure way to lose your wealth to large financial institutions, and delay or ultimately destroy your financial dreams.

Let's take a closer look at the math.

Credit card companies charge interest on a monthly basis, which means the APR must be converted to an Annual Rate (EAR).

EAR = (1+(APR/n))n-1

Basically, this means that an APR of 14.21 percent is really an Effective Annual Rate of 15.173 percent. A default APR of 21 percent is really an EAR of 23.14 percent -- seemingly small numbers that make a big difference.

The average American carries $8,562 in credit card debt. Converting this amount from an APR of 14.21 percent to an EAR of 15.173 percent means the average consumer pays $1,299.11 in interest payments. This is $1,300 less in purchasing power that goes toward interest on items previously purchased.

To reduce your debt, start by paying off liabilities with the highest interest rates. These will most likely be your credit card and other unsecured debts. After you've done this, focus on building an emergency fund so you won't become dependent on credit cards in the event of an unexpected emergency. If using a credit card is unavoidable, at least you'll have reduced your balances and interest payments for a period of time. Every little bit helps.

Since it takes time to pay off debt, use creative strategies to reduce your interest rates. Just about any other type of debt is going to have a better interest rate than unsecured credit card debt. A home equity loan for $25,000 at an interest rate of 7.5 percent is considerably better than carrying $25,000 in credit card debt at an EAR of 15 percent.

If secured debt is unavailable, spend time researching better credit card interest rates and transfer balances, but watch out for hidden balance transfer fees. These could negate the interest rate benefit of transferring a balance in the first place.

Ignore special deals, particularly store cards. Stores that offer 10 to 20 percent discounts for "vanity" card purchases know they will make their money back, plus a lot more, on inflated interest payments of 20 percent APR (or 21.94 percent EAR).

Also, watch out for "reward" cards. These cards aren't giving anything away for free. While the average credit card has an APR of 14.21 percent (EAR of 15.173 percent), the average "reward" card has an APR of 15.58 percent (EAR of 16.74). This means on $10,000 in purchases you pay an extra $157 a year in interest charges. And it's doubtful that the 10,000 points or miles you get as "bonus" rewards have a cash value of $157.

Once you've implemented a strategy to reduce your unsecured debt charges, take a look at your secured debt. Look for ways to reduce your finance charges on mortgages, cars, boats and everything else. Pay special attention to higher interest second mortgages that might have been incurred to avoid personal mortgage insurance. Pay off the highest interest rates first.

Large enterprises have entire divisions dedicated to effectively managing their debt and maximizing their institutional purchasing power and profits, while paying the least amount possible in finance charges. Individuals and families should invest similar focus and energy in doing the same. Reducing debt can mean the difference between being caught in a constant financial crunch and being able to achieve your financial goals and dreams.