It seems there is an assumption out there that everyone in the universe should understand what interest is and how it works. After counseling hundreds of folks in a mess of debt with no clue how they got there, I promise these concepts are not as widely known as every bank assumes. Today I’m going to spend some time breaking down (in simplest terms possible) the concept of interest (simple and compounding) and how/why it can work for or against you. Before you pass out from boredom, what if I told you I could make the next ten minutes worth $55,000? Read on and I’ll teach you what you need to know to make that true.
What is Interest?
For someone borrowing, interest is the cost of borrowing money. Usually expressed as a percentage (often measured in an Annual Percentage Rate or A.P.R.), interest is the amount of money you pay over and above the amount you borrowed to have the privilege to get that money and use it for a while.
For someone saving, interest is the reward you earn for allowing someone else to use your money. If you put your money in a bank, it will earn money (albeit a very small amount at current rates) simply because the bank gets the privilege of using your money for a while.
Simple vs. Compound Interest
Interest can be classified as either “simple” or “compound.” Simple interest calculates the amount of interest only looking at the original balance of an account. Let me explain. If you take out a $1,000 loan and agree to pay a simple interest rate of 10% per year, you will have to pay back $1,100 (10% of $1,000 is $100) if you pay it back in 1 year, $1,200 if you pay it back in 2 years, $1,300 if you take 3 years, etc. That’s as complicated as it gets.
Compound Interest allows interest to build (compound) on top of interest. Even though it is usually listed on an annual basis (APR, remember), interest can compound annually, monthly, or even daily. Using the example of that $1,000 loan with a 10% annually compounding interest rate, you’d still have to pay back $1,100 if you pay it back at the end of one year. However, if you wait until the second year, you’ll have to pay back $1,210 (because 10% interest was calculated on $1,100) and if you wait until year 3, you’ll end up paying $1,331 (10% of $1,210). Whether the interest compounds annually, monthly or daily will have an impact on the math, but let’s skip that complication for the time being.
Before you think this only applies to debt, know that the same examples work in reverse if you’re investing money. If you invest $1,000 at 10% simple interest, you’d pocket $1,300 at the end of year three. If you did the same at annually compounding interest, you’d end up with $1,331. Same concept, but working in your favor instead of against you.
Hopefully you’re not too confused at this point and hopefully you understand my examples above leave out one important piece – PAYMENTS! Pretty much anytime a loan has periodic payments, you’re getting into the realm of amortization and amortization schedules. A home mortgage is a great example. When you buy a home with a mortgage, you are told you’ll have X monthly payments at $Y per month with Z% APR. For example’s sake, let’s say you take out a 15-year mortgage of $100,000 at a 5% APR (and let’s assume monthly compounding this time). This means you’ll have 180 (15 x 12) monthly payments of roughly $800. Interest is calculated based on the outstanding amount owed and applied to interest and principal appropriately. See the table below from my nerdy Excel spreadsheet to see how the first few payments will work out.
Notice that after 1 year, you’ve dished out $9,600 in payments but only paid down $4,706.89 on that loan. Shew! This is interest working AGAINST you. This is why paying extra toward the principal on your mortgage can save you so much interest. Click here to download the spreadsheet I used to do these calculations if you’d like to plug in your own information. Just change anything/everything in green and the spreadsheet will do the rest.
Why Time Makes So Much Difference
We’ve spent too much time talking about debt. Let’s talk about interest in light of MAKING some money! Compounding interest can work very much in your favor if you’ll let it. Here’s an example from my e-booklet, available free to all Humorous Homemaking subscribers:
Now: if you are 30 years old and save $100 a month for the next five years and then never add another penny to it after that fifth year, you’ve contributed a total of $6,000 ($100 x 60 months = 6,000) and it is worth about $7,800.I f you just leave that money alone, when you celebrate your 65th birthday, that same $6,000 you contributed (worth $7,800 on your 35th birthday) is worth almost $140,000 at a 10% interest rate!!!
Later: if you wait until you are 35 and do the exact same thing ($100 per month for five years and never add anything to it thereafter), you will still have $7,800 at the end of five years when you celebrate your 40th birthday. When you get to your 65th birthday, that $6,000 ($7,800) will only be worth about $85,000. This is still a great amount of money, but is waiting five years worth $55,000 ($140,000 – $85,000)?
Did that help or are you more confused? If you have additional thoughts, share them!