The Power of Interest
The Power of Interest
Interest is one of the cornerstones of financial literacy, because it affects almost every aspect of our lives as a consumer. When you spend, chances are you may be paying with an interest-charging credit card, and when you save or invest, there are always interest rates stated that let you know current and past rates of return. All loans, mortgages, and lines of credit have multiple interest rate scenarios for you to sort through. Let’s start with the basics.
What is interest?
Interest is a ‘reward’ payment made to you for lending money to someone, or a fee paid to someone else (such as a bank) that lends money to you for a loan or credit card purchase. When you deposit money in a savings account, the bank is borrowing your money, and pays you interest for that privilege. The bank then lends your deposited money to someone else, at which point the bank earns interest from the person they lent money to (at a much higher rate than what they pay you). Interest is always expressed as a percentage.
Anything you purchase using credit cards, loans, in-store credit, or a line of credit, requires you to pay interest until that purchase and interest charge is paid off. It can add a great deal to the cost of the item you bought if you don’t pay it off as quickly as possible. Compared to the outrageous interest charged by credit cards, the negligible amount of interest paid on savings accounts may make you wonder if it is worth the gas to drive to the bank.
Did You Know?
- The interest rate on a 5 year mortgage in Canada in 1981 was 20%
- The Bank of Canada overnight lending rate rose to 21% in 1982?
- The United States prime interest rate reached 21.5% also in 1982?
Basic Interest Types and Rates
Simple Interest – This is interest in its simplest form – Interest is paid on the original balance only.
Example: If you borrow $10,000 at 7% annual interest, at the end of one year, you will owe the original balance (called principal) of $10,000 plus $700 in interest charges.
– Interest owed: $10,000 X 7% (.07) = $700
– Total owed on loan: $10,000 X 1.07 = $10,700
A few examples of investments that use a simple interest calculation include certain bonds, as well as various funds, ETFs, and dividend paying stocks in which the earnings are not reinvested.
APR or Annual Percentage Rate – APR is the yearly interest rate of a loan when all costs are included. On top of interest, expenses such as fees, insurance, administration costs, closing costs, etc, will be also be included in the Annual Percentage Rate. This provides the consumer with a more transparent way to compare loans from different financial institutions.
Compound Interest – Interest is paid not only on the amount of your deposit, but on the the interest accumulated on that deposit. In other words, you are earning interest on your interest! Compound interest can work against you as well, particularly with high interest credit cards. Interest compounds against you on unpaid credit card bills at an often astronomical rate.
Compound interest is one of the most powerful forces in wealth accumulation. Check out: Compound Interest – “The Eighth Wonder of the World”
Variable Rate of Interest – Unlike a fixed interest rate that stays the same, a variable rate changes over time. This means your payment amount can go up or down as well, depending on the interest rate change. The rate charged to you is usually based on a central bank’s prime rate, stated as “prime + __%”.
Variable rates are used to calculate interest charges on credit cards, line of credit loans, and sometimes on mortgages and other loans.
Fixed Rate of Interest – The interest rate on borrowing remains the same (fixed) for the entire length of the loan term. It is often the preferred choice of borrowers who want to know for sure that their payment will never rise above what they are currently paying. It also guarantees the payment remains the same, making budgeting easier. The downside is that the interest rate is higher than a fluctuating or variable rate.
Prime Interest Rate – The short term interest rate used in the banking system. It is the rate that banks use to lend to each other and to their most trustworthy customers, usually large corporations.
Banks and other lending institutions will usually lend to customers at a rate equal to prime plus an additional percentage amount that is based on the customer’s ability to repay the loan. The add-on interest rate on top of prime is based on the borrower’s risk of defaulting on the loan. Banks may lend to large and stable corporations at prime, but a variable rate line of credit loan for the average person may have an interest rate of prime + 3% or more. Credit cards can have an interest rate of Prime plus 15 – 20%.
How to Calculate Simple Interest
In order to use an interest rate in a math calculation, you first have to convert it to a decimal.
All you have to do is divide the interest rate by 100 to get a decimal.
An interest rate of 7% per year would be:
7 divided by 100 = .07
Amount of loan or investment x .07 = amount of interest paid or earned that year
How Seemingly Insignificant Interest Rate Differences Add Up
Why bother trying to get another tiny amount shaved off of your interest rate? Because those insignificant percentages add up to a lot of money over time. From a few thousand dollars over the course of ten years, to over $50,000 after thirty years shown in the example below, that money would be much better spent paying down debt or added to your retirement savings, rather than increasing bank profits. You should aim for the highest rate (within your risk tolerance) when you are saving or investing, and always negotiate for the lowest possible interest on loans.
The chart below shows the impact of various small interest rate increases or decreases on $100,000 saved for retirement. The dollar amounts in the chart show how much more you would have in savings, but could also represent how much more you would pay in interest if you borrowed that amount. These figures do not include any additional earnings you could make from investing those savings, nor do they take inflation into account. Annual interest, compounded monthly was used in the calculations.
Did You Know?
In the United States, the national average interest rate on savings accounts is only .06%, but the maximum interest that can be charged by a credit card provider is a staggering 29.99%.