The power of interest can work for or against you – make or break you financially, so to speak. Some have used it to retire early. Others have ended up in bankruptcy court because of it. How it affects you is your decision, but with a little understanding, you can make sure interest works for you rather than against you.
What Is Interest?
Strictly speaking, interest is the amount a lender charges a borrower for the use of assets. It’s typically measured as a percentage of the value of the assets.
The reality is much simpler. Most people speak of interest as the cost of money over time. It’s a price that people pay to borrow money.
For example, if you borrow $5,000 for 3 years at 6% interest and you pay the interest annually, then your first interest payment is $5,000 x 6% or $300. In that case, your cost of borrowing the $5,000 is $300 just for the first year.
Unfortunately, calculating interest is usually much more complicated than the example above.
Annual Interest vs. Monthly Payments
When people take out a loan, their interest rate is calculated on an annual basis. However, they’re almost always required to pay back the loan on a monthly basis. This is typically true of mortgage payments, car payments and credit card bills.
That complicated the calculation of the interest payment because it’s charged on a monthly basis. In the scenario above, the annual interest is 6%. The monthly interest is 6%/12 (because there are 12 months in a year) or .5%.
Now, continuing with the above loan, if you’re required to pay back the loan in monthly installments, then your first interest payment would be $5,000 x .5% or $25.
But the Interest Payment Changes
The calculation of interest payments gets even more complicated when we take into account that people who pay off a loan are typically paying off the principal as well as the interest. If you’re not familiar with the word “principal,” it’s used to describe the money that was borrowed.
Continuing with the example above, it’s not likely that you would just pay off the interest every month (such loans exist, but they’re a rare breed). You would also pay back some of the $5,000 that you borrowed plus the interest.
Fortunately, lending institutions have the capability to calculate monthly payments so that borrowers pay off a portion of the principal plus interest every month, and the whole loan is paid off by the end of the period. You can do that too, using the PMT function on a spreadsheet.
Simple Interest vs. Annual Percentage Rate (APR)
The annual percentage rate (APR) is usually more complicated than a nice, round interest rate number. That’s because the APR takes into account transaction fees, points and broker fees. When all of that is factored together, you’ll almost always end up with a number that’s higher than the quoted interest rate.
In many circumstances, lending companies are required by law to inform you of the APR. That way, you can do a quick comparison of companies and determine which loan is best for you.
It is thought that Albert Einstein once said that compound interest is “the most powerful force in the universe.” While that quotation is in some doubt, there’s no doubt that compound interest can work in your favor.
In a nutshell, compound interest is interest on interest. It’s a way to build wealth on money that you earned by doing nothing more than depositing some cash in a bank.
Here’s how it works: If you deposit $5,000 in a savings account that pays 3% interest per year, then you can expect that after one year, you will have earned $5,000 x 3%, or $150 in interest. That’s easy, right?
But what do you earn after the second year? Another $150? No, because the interest compounds. The second year, you’ll earn interest not only on the initial $5,000 that you deposited, but also on the $150 in interest that you earned during the first year. Your interest earnings the second year will be $5,150 x 3% or $154.50.
Do you see how that worked? You earned interest on your initial deposit plus the initial interest. Many people use compound interest to build wealth while they sleep.
When you use a credit card to pay for something, you’re going to be charged an interest on that purchase unless you pay it off within one month (and, in some cases, even if you do pay it off within one month). This works against you for a couple of reasons.
First, credit cards usually have high interest rates. If you buy something with a credit card for $1,000 and are charged 16% interest on the purchase, you’ll wind paying much more than $1,000 for that item.
The other reason that it’s a bad idea to use credit cards is because the credit card companies make you think they’re doing you a favor by offering low monthly payments that just take a little bit away from the principal. The reality is that you end up paying a lot more money than you should because the interest charge stays high.
Payday loans are another offer of quick cash that tempt people who need money in a pinch. Unfortunately, the cost of money for a payday loan is extremely high.
Usually, a lender will give you a payday loan in exchange for a discounted value of a post-dated check. The check is post-dated to your “payday” when you’ll have more money in the bank and can afford to pay back the loan.
However, lenders charge high interest rates and up-front fees for payday loans. It’s best to stay away from them.
Many financial advisors consider mortgages to be one of the few “good” debts. That’s because a mortgage is a loan for real estate that you’re buying. Since real estate usually (but not always) goes up in value over time, a loan to buy property is considered a sound investment.
There are countless types of mortgages, but the most common is the 30-year mortgage. That gives would-be homeowners the opportunity to finance their dream home over a period of 30 years. Since mortgages are usually huge purchases (amounts well in excess of $100,000 are not uncommon), this means that early mortgage payments will be mostly interest and very little principal. You’ll put some serious bite in the principal toward the last 10 years of the mortgage, so be sure that the property you purchase is one you really want.
Keep in mind, another reason that mortgages are considered “good” debt is because you can usually deduct mortgage interest from your taxes. Consult your tax advisor about that.
Many financial advisors consider car loans to be “bad” debt. Why? Because, unlike real estate, cars tend to go down in value over time. People who work in finance call this depreciation.
When you borrow money to buy a car, you’re not only adding to the cost of the car with interest payments, but you’re also losing money as the car depreciates in value. It won’t take long before your car is actually worth less than what you owe on it. That’s why it’s best to save and purchase a car outright as opposed to financing it.
Interest works for you when you deposit money into a savings account that offers compound interest. If you must borrow money, borrow it to pay for something that will typically increase in value over time (such as a house). If you pay high interest for common items that depreciate in value, you’re hurting yourself financially.