Compound interest adds up fast. Pay off your credit cards and high-interest loans first. (Photo Credit: CC BY/Dan Foy/Flickr)

When it comes to personal finance, few concepts are as important to understand as compound interest. Many consumer finance products use this form of interest. Knowing about compound interest can save you from a potential bankruptcy.

Compounding snowballs

The process of adding interest to principal is called compounding. Depending upon the type of personal loans, student loans, mortgages or other loans in question, interest is compounded on a regular schedule, be it daily, monthly, etc. Keep in mind that once compounding begins, interest itself earns more interest. This is a credit card company’s bread and butter, an easy way for a consumer to fall rapidly into debt. To understand the true cost of any credit card or loan, interest-related factors like how often the remaining balance is compounded and the annual percentage rate must be considered.

Compound interest should not be confused with simple interest. Simple interest is charged on principal balance only and doesn’t charge interest on accrued interest as compound interest does. Simple interest is quite rare in the field of consumer finance.

Doing the compound interest math

Here’s the math you need to know, using hypothetical numbers:

1. Divide interest charged by the amount you owe to produce the periodic interest rate. If you are dealing with personal loans in the amount of $3,500 and you’re paying $25 monthly in interest, divide $25 by $3,500 to get 0.0071428571428571.
2. Take the answer from the previous step and add 1. Now you have 1.0071428571428571.
3. Raise the result of Step 2 to the exponential power of the number of payments you make on the loan or credit card each year. If you pay monthly, you make 12 payments per year. Using the same figures, the result is 1.089163111.
4. Subtract one from the result in Step 3, which converts the compound annual interest rate to a decimal. Here, you have 0.089163111.
5. Multiply the personal loan compound annual interest rate you changed into a decimal number by 100 to create an easy-to-read percentage. Here, you’d take 0.089163111 and multiply by 100 to produce an annual compound interest rate of 8.92 percent.

Understand interest and avoid bankruptcy

Sources

Compound interest Wiki

eHow.com

Illinois Lending Corp. says the installment loans provisions of the Illinois Payday Loan Reform Act are unconstitutional. (Photo Credit: CC BY-ND/Jamison Faught /Muskogee Politico)

Beginning March 21, Illinois consumers may not have the option to choose installment loans for their emergency short term credit needs. At least one payday lender in the state is not taking what it calls unconstitutional changes lying down, reports Crain’s Chicago Business. Illinois Lending Corp., which operates six Chicago-area payday loans outlets, has filed suit in Cook County Circuit Court, claiming that its business will be irreparably harmed if the slightly longer-termed installment loans are not allowed.

Prohibition of installment loans

Unlike payday loans, installment loans have a slightly longer term, offering consumers repayment flexibility at an additional fee. This applies at the customer’s discretion, should the standard two-week payday loan term be insufficient. According to Illinois Lending Corp., prohibiting installment loans violates the company’s constitutional rights to due process and equal protection.

As it stands, two of the more problematic parts of the new Illinois Payday Loan Reform Act for lending corporations like Illinois Lending Corp. are:

• Borrowers cannot have installment loans for more than 45 days
• A new 56-day repayment period at no additional charge for borrowers who have trouble repaying

While payday lenders are not looking to exploit borrowers who are having difficulty repaying, giving them a 56-day installment loan with no finance charge attached is untenable, says Illinois Lending Corp. The company’s 2010 business records show that it made more than 7,000 installment loans and about 700 payday loans last year.

Eliminating consumer choice

Illinois Lending Corp. is asking the court to block the provision within the Illinois Payday Loan Reform Act that would bar payday lenders and their affiliates from offering installment loans.

“There is no evidence that consumers have been injured where both (installment and payday) loan products are offered in the same place of business,” the lawsuit states.

Consumer advocates want to maintain fragile compromise

Lynda Delaforgue, co-director of Chicago-based consumer advocacy group Citizen Action/Illinois, believes that if the court grants an injunction against any portion of the Illinois Payday Loan Reform Act, the other compromises struck between the short term credit industry and the state will be torn down.

“There’s the potential for consumers to be bounced back and forth between the (consumer installment and payday) products,” Delaforgue told Crain’s.

However, by uniting the products by offering both under the same roof, payday lenders say they’re offering consumers both convenience and choice. The Illinois Payday Loan Reform Act arguably threatens consumers on both grounds. Consumers who have difficulty obtaining emergency short term credit elsewhere depend upon payday loans and installment loans, according to numerous studies.

Sources

Crain’s Chicago Business
Debt Consolidation Care Forum
Illinois Payday Loan Reform Act

Restricting credit hurts consumers and payday lenders

Don't get lost in the hype critics spread about payday loans and APR. (Photo Credit: CC BY-SA/Brian Robert Marshall/Geograph)

A payday loan is a simple product that fills a specific financial niche for consumers who need quick cash but find themselves unable to obtain it via a traditional bank. Payday loans typically come to term after two weeks, and payment plus convenience fee is due at that time – usually on the consumer’s next payday – in a lump sum. The federal Truth in Lending Act of 1968 (TILA) requires that loan fees be expressed in terms of an annual percentage rate (APR), so payday lenders are required to list a loan APR for customers. As Louisville, Ky., Consumer Financial Services Association chapter spokesman Kevin Borland pointed out to the Lexington Herald-Leader in a Jan. 18 letter to the editor, this has caused no small amount of confusion for critics of the payday lending industry.

What the media doesn’t understand about APR and payday loans

Responding to a Jan. 4 editorial entitled “Put interest cap on payday loans,” Borland points to the media’s rampant payday lending confusion:

“Placing an annual percentage rate (APR) cap on a financial product with a two-week term is tantamount to charging a yearly rate for a night’s stay at a hotel. APRs are designed for mortgages and auto loans — not short-term credit,” he says.

Yet TILA requires an APR to be listed for payday loans and installment loans. Regarding payday loans, more specific payday lending laws don’t even allow for interest rates, says Borland. Thus, payday loans are fee based – it’s the only way such businesses can keep their doors open, and people have proven they’re willing to pay a premium for emergency cash.

Full disclosure

While payday loan companies clearly disclose what products cost, opponents continue to distort the truth, says Borland. While a two-week payday loan would reach a triple-digit APR if a consumer took out one loan and continued to pay a fee on that loan every two weeks for a whole year, laws in Kentucky and many other states forbid such loan renewal.

Learn the truth about payday loans

The truth of how payday loans work on a statistical level has been studied at some length over the past decade. Rather than leaping to conclusions about “massive” APR numbers, critics would do well to read the evidence against high-cost theory with payday loans firsthand.

Source

Lexington Herald-Leader

APR explanations in animated form

Paying down debt is easier if you use science to guide your decisions. Image: Flickr / Moneyblognewz / CC-BY

If you are working to pay down credit card debt, you have a lot of choices to make. Depending on how many cards you have and the amount of credit card debt, maximizing your money can be tough. Science has shown that the decisions most people make to pay down credit card debt should be re-thought.

The science of how to pay down credit card debt

In an effort to pay down credit card debt, studies have found that most people do not make the best financial choice. If given the option, most people pay down the credit card debt they can “get rid of” first, even if it has the lowest interest rate. This is because closing a loan or credit card makes it feel like you are making more progress, even if it gets you out of debt slower. Instead, the card with the highest interest should be paid off first.

Understanding credit card debt interest

The interest on credit cards should be the first consideration if you’re working on paying down debt. Cards and loans with the highest interest cost you the most money. The annual percentage rate is what the credit card company is charging you just for the privilege of owing money. The highest interest rate costs you the most money and compounds the fastest. Even if you have a small loan that you could pay off, it is smarter to put money toward the highest interest debt.

Basic steps to pay down credit card debt

Now that you know which credit card debt you should pay down first, how do you go about it?

1. List all your debts. Order them by interest (APR) and start paying on the highest interest ones first.
2. If you don’t have one, create a basic household budget to find out how much you can spend to pay down credit card debt.
3. Pay more than the minimum amount. Minimum payments keep you in debt – paying extra means paying it off.
4. Find extra money to pay down your debt. Try recycling or finding a part-time job.
5. Don’t raid your savings. While it may seem like an easy answer – borrow from your 401k or house – leaving yourself some breathing room for unexpected expenses is important, lest you end up having to use your credit cards and end up in debt all over again.

Source

Marketplace

New Fed restrictions are expected to take effect in October 2011, at the earliest. (Thinkstock)

The Great Recession occurred largely as a result of unsafe lending practices that allowed consumers to exceed their means and drag the nation’s economy down with their personal finances. The extent to which this occurred could have perhaps been decreased if more proactive federal regulation had taken place.

It appears as if the Federal Reserve learned its lesson from the national financial swoon as it recently announced regulations that serve to close loopholes within the new credit card law (CARD Act) before they cause significant damage. Such a move comes in refreshingly severe contrast to the laissez fair-type policy practiced by the Fed for the last decade and seems to be a positive sign for the financial well being of the United States.

CARD Act background

The CARD Act — which took full effect in August — instituted numerous consumer protections designed to curb the predatory, harmful credit practices that were previously allowed to perpetrate unchecked and helped lead to the nation’s financial malaise. While this is the most sweeping piece of credit card legislation passed in years, sometimes vague language has allowed certain unscrupulous credit card companies to continue dangerous practices.

APR change protections

Prior to the Fed regulations, the CARD Act stated that issuers could not change a consumer’s interest rate during the first year that an account was open or apply increased APRs to existing balances unless consumers were at least 60 days delinquent. Such rules even pertained to accounts with introductory rates. However, some companies evaded the spirit of the law by offering to waive consumers’ APRs for a certain period of time while retaining the self-conferred right to revoke the waiver at will. For example, instead of offering you a 0 percent APR credit card, they would give you a card with a 15 percent APR, that they would offer to waive for the first 12 months. Their rationale was that waiver revocation would not be an APR change rate but merely a re-instituting of a normal rate. However, the Fed restrictions — expected to take effect in October 2011, at the earliest — close the door on such fee waivers.

Fee limits

The CARD Act also prohibits credit card companies from charging more than 25 percent of a card’s limit in fees during the first year an account is open, a provision that affects bad credit credit cards most significantly. Certain companies found their way around this by charging processing fees that had to be paid before an account could be opened. These fees, according to issuer thinking, did not count toward the 25 percent limit because they were not assessed during the account’s first year. However, like the fee waivers, this semantic interpretation was nullified by the Fed’s decree.

Income Determination

The Fed also banned the use of household income as a determining factor of a consumer’s ability to pay, holding that personal income will provide a far more accurate indication of how much debt someone can afford comfortably. This distinction will help protect people from the widespread severe disparities that existed between amounts owed and means of payment prior to and during the recession.

These Fed changes will surely provide consumer aid upon taking effect, but their larger implication is what’s truly important. If the Federal Reserve continues to address issues before they become significant problems, the chances of facing another recession down the road will decrease significantly. This organization had not acted so swiftly in more than 10 years, so it appears as if a policy shift has taken place. However, once could be a fluke, but two or three make a trend, so pay close attention to how the Fed acts in the coming months. Its behavior could serve as an apt indicator of our economic future.

Liability considerations

It is a common belief that business credit cards confer some measure of financial liability protection to small business owners. The perception is that because these cards serve business purposes, any financial difficulties encountered while using them ultimately falls not on the owner as an individual, but on the business as a separate entity. This is not the case, however, because lenders make no distinction between a small business owner and his or her company. Unlike with larger businesses, small business liability is personal liability. Therefore, one advantage commonly attributed to small business credit cards is actually nonexistent. This fact becomes especially important when the effects of the new credit card law (CARD Act) are considered.

CARD Act implications

Among the many regulations instituted as part of the CARD Act are stipulations prohibiting lenders from applying increased interest rates to existing balances or implementing penalty APRs until a consumer is 60 days delinquent. While these changes do provide significant consumer benefit, they only apply to personal credit cards. Therefore, a bank can assess an arbitrarily increased interest rate on a balance held with a business credit card, thereby making a user’s credit card debt more costly. This fact makes use of such cards inherently risky for carrying debt, as it is a common practice for credit card companies to raise interest rates as a means of quickly increasing profits. Thus, a small business owner should employ a personal credit card for this type of spending because of the protection and stability it will provide.

Still, having a business credit card for smaller purchases that will be paid for in full each month is a good idea, as well.

Business card utilities

Business credit cards should be employed for all purchasing that does not expose one’s balance to vulnerability because such cards have certain features that make them apt for business use. More specifically, business credit cards provide better reporting that allows users to easily track and monitor business purchases as well as give cards with personalized limits to employees, which owners can then earn rewards on.

Recommendations

Personal and business credit cards have inherent perks and drawbacks. However, when used correctly in concert, they provide a net benefit to small business owners. A user must simply remember to fund any purchases that will lead to a balance with a personal credit card and all others with a business credit card. By doing so, this person will be able to manage his or her small business with the predictability and cash flow stability necessitated by the current state of the economy and precluded by unexpected cost-of-debt increases.