There’s a famous saying that “compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.” While the quote is often attributed to Albert Einstein, who likely didn’t actually say it, the concept is very true.
Most people associate interest with payments, and money going out. What is often forgotten is that when interest works for you, it can work wonders. Plus, you don’t need an advanced degree to understand how it works. Continue on to learn how interest rates work and how they impact your money.
Interest is money paid to borrow funds or money earned from depositing funds. Interest rates tell you how much is paid or earned based on a percentage of the original amount, known as the principal.
Simple interest is a one-time interest charge for borrowing money for a period of time. Compound interest includes interest on past interest. For example, with a credit card that compounds monthly, this month’s interest charges may include any unpaid interest from last month.
For the rest of the article, we’ll mostly look at interest rates as a borrower. However, they work just the same when you are on the other side earning interest with a savings account, CD, or investment.
One of the most common places to run into interest is with a credit card. Credit cards don’t charge interest if you pay them off in full by the due date. But if you don’t pay the statement balance in full, interest applies to the amount you carry from month to month.
Credit cards charge interest rates ranging from 0% to around 30%. As with most loans, your interest rate is generally higher if you have a lower credit score. With excellent credit, you qualify for the lowest rates.
Let’s say you have a credit card with a 25% interest rate and a $1,000 average daily balance over the last month. The bank will base interest charges on that $1,000 daily average rate even if your balance at the end of the month is lower.
With a 25% interest rate, your daily interest rate is 25% divided by 365, or .00068. To calculate your monthly interest, multiply that number by your daily average balance. .0068 times $1,000 is .6849. Multiply that times the number of days in the billing period (let’s go with 30), or .6849 times 30. The result is $20.55. That is this month’s interest charge.
The interest becomes part of your balance. If your interest is more than you pay back, your balance can grow each month instead of fall. This growing balance problem is common with payday loans and some student loans on income-based repayment plans.
If you follow the news, you have probably seen interest rates come up often over the last few years. The Federal Reserve Bank, the bank of America’s banks, sets a target interest rate that flows through into other parts of the economy. When rates go up by 0.25%, you will probably see your credit cards and bank accounts follow suit.
Some loans, like a fixed-rate mortgage, have an interest rate that is locked in and won’t change for the duration of the loan. Others, like credit cards and other variable rate loans, typically follow market interest rates.
If you’re struggling to pay the bills, a payday loan or credit card could be a tempting route to fast cash. But the relief from using these types of loans is only temporary. High interest rates can rack up interest quickly and leave you struggling to keep up. If you can avoid taking out high-interest loans, your finances will be much better off.
On the other hand, if you are able to turn a borrowing habit into a saving habit, you’ll start earning interest. Savings accounts are the best places to start, and most of the best deals today come from online banks that pay higher interest rates with no monthly fees or minimum balances.
Now that you know how it works, you can put the “eighth wonder of the world” to work for you. That’s what good personal finance management is all about.
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