The Average Cost of Debt
Consumers commonly borrow money for many different purposes, from buying a house or car to paying college tuition or making everyday purchases. Whatever the reason, when you borrow money, it's important to understand the cost of your debt. The average cost of debt varies by the type of loan and the borrower's behavior.
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Interest Rates
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The first and most basic cost associated with debt is the interest you pay to borrow money. Interest rates vary based on a number of factors, including the type of loan, your credit score and the status of the economy. Home mortgages, for example, typically have interest rates anywhere from 3 percent to 5 percent. The cost of a home means that even a fraction of a point difference on a mortgage can mean thousands of dollars saved, or spent to borrow. Auto loans typically charge interest in the 4 to 5 percent range, while credit cards charge upwards of 16 percent. In each case, the interest rate is an APR, or annual percentage rate. Since most loans charge interest monthly, a 5 percent APR means it costs 5 dollars to borrow 100 dollars for one year.
Additional Interest Costs
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Monthly interest isn't the only time that interest adds to the cost of debt. The average borrower has a loan that allows interest to accumulate if the borrower doesn't pay it off on time, which creates compound interest on top of old interest. Negative amortization refers to an option on some loans that allows the borrower to pay less than the interest charge each month, causing the principal of the loan to rise instead of decrease. Some loans, such as adjustable rate mortgages, also have rates that can go up over time, increasing the cost of interest once a short period of low interest expires.
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Fees and Penalties
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Borrowing money can lead to fees or financial penalties that expand how much your debt ends up costing you. Some fees, such as those that come with mortgage loans, are unavoidable, which means the average homebuyer needs to factor them in when calculating the total cost of borrowing. Other fees only show up when borrowers miss payments or overextend a line of credit. Penalties include prepayment charges for borrowers who pay off their loans early.
Opportunity Cost
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Another important factor in the cost of debt is the opportunity cost that borrowing money always represents. Borrowing money and taking on the debt burden it brings means less money to spend or invest elsewhere. This is an issue for businesses that have large amounts of debt and can't afford to invest in expansion because of their high monthly interest charges. The average opportunity cost is impossible to calculate, but for some borrowers it can mean the difference between a successful transaction and a harmful one.
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