Understanding Interest

by Brandi Savitt – July 29, 2010

It Pays to Know More

It is seriously mind numbing to think about how they figure out interest rates and how it all really works.  After all, who really cares when at the end of the day you are just trying to pay the minimum due on all your  bills each month and keep your head above water.  It’s out of your control, right? WRONG!

The reality is, if you’re interested in getting a mortgage, leasing a car, taking out a business loan, getting out of credit debt or saving for ALL of the above, understanding how interest and interest rates impact your everyday life will help you realize how YOU can change your financial future – FOR THE BETTER!

Over the past forty years, we have fundamentally changed how we deal with money in our society.  It is safe to say that we have all grown up living in what we like to call a DEBT culture.  In our banking and borrowing lives, we all have paid interest and have had interest paid to us, but we also have been taught that this is the norm – AND IT IS.  However, because paying interest is a part of life as we know it, we also tend NOT to think twice about how much extra we are paying for the convenience of having credit  and the costs of borrowing money.  But when you think about it in simple terms of actual time and cost, you can make more informed decisions that will help reduce your debt or add to your savings much faster.  Instead of interest being just a fact of life, use it to your best advantage and help you take control of your financial future by saving you and making you more money!

Definition of Interest

Simply put (by Wikipedia), interest is a fee paid on borrowed assets.  It is the price paid for the use of borrowed money or money earned by deposited funds.   Interest can be thought of as the “renting of money”.  Interest is compensation to the lender, and for forgoing other useful investments that could have been made with the loaned asset.  It also compensates the lender for the risk of losing the principal.  In economics, interest is considered the price of credit.

Types of Interest

We’re not going to  bore you with mathematical formulas, politics and advanced economic theory that goes into how interest rates are determined, but understanding the basic concepts of the two main types of interest will help inform you what loans to pay off first or what types of investments will give you the greatest benefits.

Simple interest

Simple interest is calculated only on the principal amount borrowed, or on that portion of the principal amount that remains unpaid.  This means, if you owe $100 in principal and your interest rate is 10%, you will only ever owe $110.

Few loans are calculated this simple way, but it is important to first understand this concept to fully understand the different in how other interest is calculated.

Compound Interest

Most loans and savings accounts are calculated using compound interest.   The difference between simple and compound interest is that compound interest is calculated on both the principal and the accrued interest.  In other words, the borrower is charged interest on previous interest.   Or as an investor, you make money from your earnings.  This why it is so dangerous to have credit card debt, or on the other hand, is a main reason to take your cash out from under your mattress and put it into an interest baring investment!

Interest Rates

An interest rate is a predetermined fixed (unchanging) or variable (subject to change) percentage at which interest is paid by a borrower for the use of money that they borrow from a lender.

Interest rates vary depending on the type of loan, the risk factor involved, the duration of the loan, the inflation factor and any possible tax advantages.  The government does regulate rates to some degree, but it is up to YOU to fully investigate, understand and try to negotiate the best rate for what ever loan, credit card or investment you are signing yourself up for.

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One Response to “Understanding Interest”

  1. Shelby says:

    Always informative and helpful!!! It is so frightening when you stop to think how much the interest on these credit cards is really costing us. My advise is to pay them off as quickly as possible. You most likely won’t miss $20 bucks a month, but it sure is amazing how much it can save you when you apply it to your credit card or loan payment.

Any Thoughts?