As we close in on Valentine’s Day, I’d like to talk with you about interest. But not your interest in that attractive person you have on your radar. Interest on debt. And interest on investments.
Did you know that there are two different kinds of interest? Many people don’t realize this. Simple interest and compound interest are two very different things. And they are both good in the right situation. And they are both bad in the wrong situation.
Simple interest is what most people think of when they borrow money. When you borrow a car loan or a student loan or a home mortgage, simple interest is what you will typically encounter. Simple interest is calculated based on the amount of the principal of the loan. And only on the principal. So if you borrow $100,000 at 8% interest, your payments will be amortized out over a designated number of years (10 or 25 years for a student loan, usually 30 years for a mortgage, and typically 4 to 7 years for a car loan). Your payment will consist of a portion of interest and a portion of principal. Let’s say that $100,000 at 8% is amortized over 10 years. Your first payment would include $6,085 in principal and $7,754 in interest. But the next month’s payment would be based on $93,915 in principal, so the interest would be only $7,189. And as you progress through the ten years of the amortization, your payment consists of less interest and more principal every month. Eventually, somewhere in the middle, you reach a point where you are paying more in principal than in interest each month. But you have never had to pay interest on more than the $100,000 you initially borrowed.
In a savings or investment situation simple interest is NOT what you want. In that situation you would earn interest only on the principal. If you invest $100,000 at 8% you would earn only $8000 in interest for the year. But if that interest were compounded each month, you would earn $8,300 because in addition to earning interest on the $100,000, you would also be earning interest on the accruing interest.
So you can probably see where I am going here. Compounding interest is calculated based on the principal plus any interest that has accrued. And in a savings or investment environment, that is exactly what you want, because it makes your money grow faster.
In a debt situation, compounding interest is the enemy. And that is exactly how credit cards work if you don’t pay them off in full every month. Let’s assume that you put $2,000 on a credit card at 18% interest, and you pay only the minimum monthly payment of $100. You would think that at that pace it would take 20 months to pay off the $2,000. But because the interest compounds (quite often daily) it would take at least 24 months to clear that $2,000 debt. Credit card companies quite often compound your interest daily. That 18% interest rate on $2,000 calculates out to about almost one dollar a day. So every single day the credit card company is adding a dollar to your balance due. Compounding interest is exactly what you do not want in a debt situation. Does this make you want to go read the small print on your credit card statement to find out how often they compound the interest? It probably should.
Interest can be scary. But it can also be your friend. In debt you want to keep things simple. In investments you want things to compound. But either way, I hope you found this INTERESTing.
