The Crazy World of Interest

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Sometimes people do not understand what they are getting into when they borrow money or buy things on credit. People come to me complaining that large portions of their paycheck is going toward interest on their loans, and there is not enough money left over to pay their bills.

People borrow money for a lot of reasons: Maybe they want to buy something big, like a house or a car, or they have a wedding to pay for. Sometimes they need to pay for college. And sometimes, they just need to get their hands on some cash so they can pay their monthly bills.

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When people borrow money, the lender is out that money for a period of time and cannot use it for other things. Because of this, the borrower may have to pay the lender extra money, (they call that interest), so that the lender will be ok loaning out his money. Also, there is a chance that the borrower may not be able to repay the loan. Because of this, the lender may charge more interest if he is nervous about whether the borrower will be able to repay the loan.

Here are some types of loans we frequently see our clients have.

  • Secured loans: These typically come with the cheapest interest rates. Examples of secured loans might be:
      • home mortgage where you give the bank the right to take your home if you don’t repay the loan
      • car loan where you give the bank the right to repossess the car if you don’t pay the car note
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The bank can then sell the home or car and get its money back that way.

  • Unsecured loans: This is a loan where the bank is relying on your promise to repay the debt. In the agreement, however, you do not give the bank the right to take any of your property if you don’t make your payments. Examples of unsecured loans might be:
    • credit card
    • personal loan
    • line of credit with your bank

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If you can’t repay the loan, the bank is limited in what it can do to get its money back. Other than making repeated demands for you to repay the loan, the bank may have to file a lawsuit and try to collect on the debt using the courts and the sheriff. This is expensive and may not always be worth it. Because unsecured loan agreements do not give the bank the right to take or repossess your property if you don’t repay the loan, the bank usually charges more interest to compensate for its increased risk of losing its money. The ability to charge higher interest rates for unsecured debts turns out to be a huge money maker for the banks even though people sometimes default on their loans. Because of this, many creditors are very willing to lend money to those who have poor credit histories.