by Kathiann M. Kowalski
When it comes to money matters, interest can be a friend and a foe.
A Friend
When you make a deposit in a savings account, the bank usually agrees to pay monthly interest to you as its customer. That payment of interest is in return for the bank’s ability to use the funds until you need the money back. Suppose you deposit $100 in a savings account and the bank’s annual interest rate was 1 percent. The bank would give you $1 at the end of a 12-month period—just for putting and keeping your $100 in the bank.
A Foe
On the flip side, if you borrow money, you typically pay interest to a bank or a lender. You agree to pay back the full amount of the loan and to pay interest for the use of the money. Suppose you borrow $100, and you agree to pay it back at the end of a year at a 5-percent interest rate. You would have to pay $105. The $100 is the principal, and the simple interest rate is 5 percent, or 0.05 times the principal. (In financial matters, the principal is the amount of money put on deposit in a bank account or borrowed from someone else.)
But interest is not always so simple. In fact, it often is more complicated.
Compound Interest
Many financial transactions use compound interest on deposits and loans. Compound interest is interest paid on interest. Suppose you deposit $100 in a bank account that pays a 3-percent interest rate, compounded daily. If you made no more deposits and no withdrawals, you would earn $16.42 after five years. Interest on the accrued interest would get you more than the $15 a simple interest rate would pay. (Accrued means accumulated or built up.) In other words, you will earn more money over time because the interest you earn is added to your principal amount. As that number increases, 3 percent of it results in larger interest payments overall.
Here’s another way to see how compound interest works. The chart below represents the interest to be earned on a deposit or paid on a loan over a five-year span with a starting principal of $1,000 at a 5-percent interest rate compounded annually, monthly, and daily:
Annually Monthly Daily
Year 1 $50.00 $51.16 $52.00
Year 2 $102.50 $104.94 $106.70
Year 3 $157.63 $161.47 $164.24
Year 4 $215.51 $220.90 $224.78
Year 5 $276.28 $283.36 $288.47
Things to Remember
If you deposit money in an account, the longer the money stays there, the more interest it generates. The more frequently the interest is compounded, the more money it generates. And the higher the interest rates, the greater the yield to you in compound interest. The flip side is if you take out a loan. In that case, more frequent compounding, higher rates, and longer term of the loan can all cause you to ultimately pay more.
Really Big Dollars
Suppose your family borrows $100,000 to buy a home. And suppose the lender charges an interest rate of 5 percent. Most home loans are for either 15 years or 30 years. A common loan term of 15 years would have monthly payments of $791. At the end of 15 years, your family will pay more than $142,000. For a loan term of 30 years, the monthly payments would drop to a lower amount—$537. But the total amount paid on the mortgage at the end of 30 years would be nearly $193,000. Your family will end up paying more interest for borrowing money over a longer period of time.
Another Wrinkle
Interest rates can be either fixed or variable. (Fixed means remains unchanged. Variable means changeable.) If you sign a loan with a fixed interest rate, your monthly payment amounts won’t change for the life of the loan. But payments on a loan with a variable interest rate can change. Variable interest rates often start at a lower rate than a fixed interest rate and remain low for the first few years. But the rate can change periodically as market conditions change. When the rate goes up, as they often eventually do, that means your payments will go up, too.
So, have we grabbed your interest? The more you know about interest, the better you’ll be at managing your money.
Try These Tools
Multiple websites explain the math behind interest calculations and offer tools to speed up the process. Here are a few:
Financial Mentor Compound Interest Calculator
