401(k)'s, Principal and APR
Before we begin, if you’re reading this in your email and see “Anonymous” as the author, that’s due to a system issue I’m working to resolve. Until then, please understand that it’s still just me…
We’re getting close to the end of the list of finance terms Americans were recently polled about by YouGov. We started with terms like “index fund” and “amortization”, which relatively few folks were comfortable with. Now we’re into terms like 401(k), principal, and APR. Each is approaching the point where almost 2/3rds of us are familiar with the terms. How well do you know them? Read on for a brief explainer for each, from the perspective of your humble financial planner.
401(k) – Beware of unintended consequences. Back in 1978 Congress inadvertently created the 401(k) plan that we know today. Interestingly, the obscure section of the tax code was never intended to become the primary retirement savings vehicle for American workers. But it did and the rest, as they say, is history.
Before ‘78, a good chunk of workers had a traditional “defined benefit” pension plan. You’d work for a company for many years and each year the company would make contributions on your behalf to a general pension fund. This was (and still is) regulated by the government and the company would have to show, based on accepted criteria, how close the plan was to being “fully funded”. The company then had the responsibility of managing the fund’s investments so that it could meet its current and future pension obligations to retirees. While this was great for workers who could rely on a stable retirement without having to do much more than cash checks, it was incredibly expensive and risky for the employer.
This fundamental tension ultimately led to the small provision in the tax code being leveraged into the retirement-savings juggernaut we know today. Also known as a “defined contribution plan” because workers decide to make their own contributions, 401(k) plan balances currently amount to roughly $5 trillion. But this isn’t a replacement for traditional pensions, not by a long shot. Only about 53% of workers have a 401(k) available and a third have no plan at all. For those workers with a 401(k), the typical balance at Fidelity, for example, the largest company in this space, is about $25,000.
For all the perceived benefits for workers (pre-tax savings, funding flexibility, making personal investment decisions, etc), many experts, including those who started the 401(k)-ball rolling, regret what their creation has become. Why? Because the 401(k) structure transfers the risk and funding burdens from the employer to the employee, who is generally unprepared to take it on. This benefits employers but leaves many Americans woefully unprepared for retirement, even if they don’t currently realize it.
Principal – Your principal is the original amount of money you invested or borrowed. While you could always have a mental reset and consider any recent savings balance to be your “principal”, technically it’s the amount you started with. With loans, it’s the current amount you owe.
Say, for example, you invested $100 in Crazy Growth Stock Inc. and after a few years your original investment is worth $100,000. Aside from being very proud of yourself, you’d have $999,900 of capital gains and your $100 of principal. The $100,000 doesn’t become “principal” until you sell the stock and buy something else. Or, you could be super technical and track the original $100 investment into the new stock, or whatever it is you’re investing in.
This is similar when thinking about debt. If you borrow $100,000 at 10% interest amortized over ten years, at the end of the first year you’d owe about $94,000 of principal even though you had been paying about $1,300 per month, because interest was included in your payments. If this was an interest-only loan, after 12 months of payments you’d still owe… $100,000, meaning the principal amount of your loan hadn’t been paid down at all because you were just paying interest. Ideally, you’d want to see the principal balance on your loan decline over time so that, eventually, you’d reach the Mythical Land of Interest Free.
The reason understanding your principal amount matters, whether it’s an investment or with debt, is that it’s a way to track how far you’ve come from where you started. If you’ve invested for a long time and your principal hasn’t made much, that’s a problem. Or, if you’ve been making mortgage payments for years and, after a few refinances, you still owe basically the same principal amount, that’s a problem too.
Annual Percentage Rate (APR) – Reviewing a loan or credit card’s APR is a handy way to compare different loan options. As the name implies, it’s an annualized look at what the debt would end up costing over the span of a year. You could think of it as your average rate. Lower is better but it’s all relative.
An APR differs from a basic interest rate because it can include fees and other charges. This helps when you’re confronted by lower interest rate offers that come with strings attached. Is it worthwhile the pay a fee upfront to get a lower rate? Or, is it better to choose the higher rate option? Which fits your situation best? APR provides that big-picture look to help you decide.
So, always ask for the APR when you see a basic interest rate being mentioned. If the APR is higher than the rate you know there are fees and other charges baked into the deal. Lenders may not include everything in their APR, so you have to ask for a list of what is and isn’t included. Doing all of this might seem annoying, but it’s important information for making informed borrowing decisions.
Here’s a link to the YouGov information if you’re interested:
Have questions? Ask me. I can help.
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