Understanding Interest: Things to Know
Without a calculator or Google, can you answer the following questions? If I borrow $2500 for the year at 9.25% APR, what is the total amount that will need to be repaid? Better yet, how much money will I get each year if I invest $2500 into a CD at 2.08% APY? The interest rates can make it complex.
Confused? You’re not alone. As reported in both TIME and Fortune, nearly two-thirds of Americans cannot calculate interest payments correctly, let alone pass a basic financial literacy test. This is a very dismal statistic, to say the least, and might explain why so many are having financial difficulties these days. Thankfully, it is one problem we can fix for you right now. If you want to master your finances, you need to understand what interest is and how it works. It is actually fairly easy to understand once you get the basics down. Here is an overview that might help you along.
“Interest” (in this context) is defined as: money paid regularly at a particular rate for the use of money lent, or for delaying the repayment of a debt. So basically, interest is the cost of borrowing money. This could be money that you borrow from a lending institution or money your lending institution borrows from you. To say this yet another way, interest is the money you will pay when taking out a loan or money you will receive when you deposit or invest your money.
Unfortunately, you will deal with a lot of lingo when discussing or researching financial matters. These terms include things like “Principle” and “Capitalization.” Again, super easy once you get the basics down.
Principal: This is the actual amount of money borrowed. If you borrow or deposit $2500, “principle” represents that amount.
Interest Rate: The best way to think about interest is to understand that it is the cost of borrowing the funds, and it is expressed as a percentage of the principal. This percentage is the actual interest rate or “rate of interest.”
A simple way to understand interest is to look at something called “simple interest.” Although your investments and debts are more than likely calculated using different methods, simple interest can help us understand what interest is and how it works. Simple interest (I) is calculated by multiplying Principal (P) times the percentage rate (R) times the number of time (T) periods. Maybe a better way to say it would be that the total amount of interest that you actually pay depends on how much “principle” you borrow (or lend), the rate being charged, and the length of time to repay the debt.
Compound Interest: Compound interest is interest earned on top of the original amount and the cost of borrowing the funds. Let’s say that you have a rate of 1% APY. You started out investing $100. You would earn interest totaling about $1.00 over the year. You would then have $101.00. Now, if you keep ALL that money invested for another year (including the interest earned in the first year), the following year, you would have earned $1.01. Now your total is $102.01. This compounds each year. Essentially, you will earn just a little more each year because the interest earned in the prior year now becomes a part of the principle.
APR: This stands for “Annual Percentage Rate.” APR shows you how much interest you’re PAYING annually for a loan or revolving credit.
APY: This stands for “Annual Percentage Yield.” APY shows you how much you’ll EARN in interest on deposits accumulated over the course of a year.
Accrual: Depending on how the agreement is set up or even how you decide to pay on the debt, the cost of borrowing (interest) accrues (accumulates) on loans from month to month. When this happens, the interest is growing daily. To figure out the daily interest, you would multiply the loan balance by the number of days since the last payment, then times that by the interest rate being charged.
Capitalization: This is the UNPAID interest that is added to the principle when payments are postponed. This can include forbearances, deferments, or even grace periods. Example: Let’s say you had to miss a payment for some reason. That interest payment was missed, along with the payment on the principal. So if a lender had to capitalize $250 worth of interest on a principle of $2500 at 10% APR, the borrower would now owe $2750 at 10% APR. This increases the total owed and may increase the number or size of the original payment.
Playing the Game
Getting a loan has to happen from time to time, and investing your money wisely is always great. The goal is to pay as little interest as possible when paying on debt and to earn as much interest as possible on investments. That can sometimes be difficult, but here are a few tips that might help.
When Paying on a Debt
When paying off your debts, you want to “strategize” as much as possible. Pay a little extra each time you make a payment or make payments when you are not required to do so. In other words, pay more than just the minimum when possible. This reduces the amount of principle, helps to avoid capitalization, and will reduce the amount of interest being paid as a result.
Some lending institutions will bump a rate in your favor if you place your checking and savings accounts with them. They may also bump a rate in your favor if you enroll in direct deposit and Auto Pay programs. Ask your lending institutions if they have such programs or find an institution that does. You might be able to refinance your debt with the new institution.
Improve your credit rating. This can be done by paying your bills on time, paying off loans and credit cards early, refinancing for a better rate, and paying off any other debts or collections. If you don’t have credit or if your credit is bad, you can take out secured loans, which can provide you an opportunity to show solid payment history and ultimately help build or rebuild your credit. As your credit rating improves, your loan interest rates will drop.
Seek out the best rate of return. Don’t know much about investing? That’s okay too! Save up a little money by putting it into an interest-bearing savings account and then let it build for a while as you continue putting more into the account. Once you have somewhere between $500 to $2500 to start investing, have a conversation with your lending institution’s financial services representative or chat with a financial adviser. They will put you on the right path.
Let me close with one more simple tip. You can do this whether you are just starting out or have been at it for a while. The tip is to move your funds (checking, saving, etc.) to a credit union. Credit unions typically pay higher rates on all deposit accounts, including savings, money market, and checking accounts. And yes, it’s worth the effort. Credit unions typically offer rates anywhere from 4 to 10 times higher than you would receive from your local commercial bank. Go see for yourself.
Keep learning! Check out my article titled, “How to Avoid Overdraft Protection Fees at the Bank.”
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