There is a cost to not understanding financial language.
Last week we began the series asking, are you financially literate? Financial literacy is a language all by itself, but you don’t have to become overwhelmed or become an expert. You can improve your knowledge by focusing on the basics in the area of your immediate interest.
For example, if you are interested in acquiring a vehicle but don’t know whether to lease or buy you may need to become familiar with phrases or terms such as lease with option to buy, acquisition fee, adjusted capitalized cost, residual value or regulation M (Federal Reserve Board’s Consumer Leasing Act, which requires full disclosure of all leasing cost). Once you have a solid handle on the terms and their meanings you can navigate your next financial decision successfully.
The problem is, many people are speaking in tongues when it comes to financial literacy. They either don’t know or they think a word or phrase means one thing when in actuality it means something totally different. This is how people make financial decisions that are not in their best interest. Today we’re going to talk about interest. What does it mean, and how does it work?
Average vs Median
It’s Spring and you are house shopping. Your realtor tells you the average house in the neighborhood costs $35,000.00. You think to yourself, “I don’t want to pay more than the average cost of homes for my house.” Well, let’s look at the numbers and their meaning. If the homes you are looking at cost $10,000; $11,000.00; $13,000.00; $15,000.00; and $90,000.00 respectively, what is the average and the median cost of these homes?
The average is calculated by adding the numbers together and dividing it by the total amount of numbers. Contrastingly, the median is calculated by arranging the numbers from lowest to highest and selecting the number in the middle. In this case the average cost of homes in your potential neighborhood is $27,800.00, while the median cost of the houses in that neighborhood is $13,000.00, the number in the middle.
The house costing $90,000.00 has skewed the more accurate cost of homes in your potential neighborhood. But if you don’t understand the financial literacy language, it could lead to poor choices when deciding whether or not to purchase a house. If you know the language, you can also engage in more constructive conversation with your realtor and other professionals getting the proper information needed.
Interest: Annual Percentage Rate (APR) and Annual Percentage Yield (APY)
You want to get a new credit card to consolidate your debt and you see an offer of 8 percent on this new card. You think that the interest rate you are going to pay on your new credit card is 8 percent because that’s what you were told when you acquired your latest credit card. Translation!
Interest is what you pay if you purchase some item on your credit card and fail to pay the full amount borrowed when due. But that’s not the full story.
APR includes your interest rate plus additional fees. There are three types of APR. There is a Cash Advance APR, which is the cost of borrowing cash from your credit card. This APR tends to be at a rate higher than the advertised 8 percent.
There is a Penalty APR which usually is the highest APR. It may also be applied to certain balances when you violate the card terms and conditions like failing to make payments on time. They know you are going to pay late or miss a payment, and that’s how they are going to make their money, so they plan or structure the APR with you I mind.
Finally, there is the Introductory or Promotional APR. This option features a lower APR for a limited time period. It can apply to specific transactions such as balance transfers, cash advances, or any combination. In attempting to consolidate your debt other transactions on one credit card you may have fallen prey to a promotion APR. If you are not careful or on top of these payments, before you know it, fees and payments get out of control.
Ultimately, your Annual Percentage Yield (APY) tells you how your interest rate is compounded. Your interest rate can be compounded daily, weekly or monthly. APY is usually higher or more than your APR since it includes the compounding of interest and APR amounts. Here’s one take away! If you don’t know the language, how can you know what you are looking at when you decide to change your credit card for a lower interest rate. Make sure you’re taking the time to understand the terms and meanings of every financial venture you embark upon. It will save you time and potentially thousands of dollars.
Consumer Price Index (CPI) Inflation and Bank Interest Rate
The CPI measures the average monthly increase in the cost of consumer goods. That’s the stuff you purchase on a monthly basis that keeps going up, like groceries. What’s important for you to understand is that inflation is the purchasing power of your dollar every time prices go up. Said another way, you’ve got to determine how much you can spend on groceries with the same amount of money in your paycheck.
Here’s how this relates to your bank account. If the CPI is going up and inflation is going up, that means the cost of your groceries are increasing. The problem is, you received the same gross income last month this month. This means that you either have to buy cheaper quality or less food. The financial question you must ask yourself is, why are you keeping your money in a bank savings/checking account that is only giving you 0.01 or less than 1 percent interest? Less than the annual rate of inflation? I spoke to someone last week who told me that they have been holding $45,000.00 in a checking account for the past three months. Needless to say, I almost had a seizure!
The takeaways for today are before you begin to execute on financial decisions invest time in becoming familiar with the lingo. Purchase some books, do some reading and talk with people who are knowledgeable to help you understand. If you fail to get comfortable with financial literacy you may end up with a language barrier that could result in severe financial consequences.