Alright, so we’ve all dealt with interest. Whether it’s paying it on a loan or earning it on a CD, it’s affected everyone who deals with personal finance. But, do you understand the math behind the interest? Does it work the way you assume it does?
When you consider options like a loan for an easy payday at Personal Money Network, what does interest look like? How much are you going to pay for online payday loans for bad credit? And how much are you going to expect to get if you’re investing in something?
There are two ways that you can be charged or earn interest: Simple interest and compound interest. Usually the former is for being charged interest on a loan, and the latter for earning interest on one of your investments. Let’s look at how each of these work and how much of a difference it can make when you’re dealing with money in any context.
Simple interest is interest that is accrued on the original balance. It never considers interest that is previously paid, even if you keep it in that account.
For example, say I take a loan out for $1,000 and it has a 5% interest rate per year. So yearly, I pay an extra $50. If my interest were to be calculated using simple interest, every year I would always pay $50 extra, because it would be based on how much the loan was to start with. So after 5 years, the financial institution that you borrowed from would get $250 from you.
Now, just from that example, you can see where this would be absolutely horrible when dealing with earning interest. Imagine you invested $1,000 and you earned 5% on the original balance every year.
That is not going to end up being a very good investment for you, no matter how you look at it. After 5 years you would have only earned $250. Now, that is a decent amount of money, but at the same time, you’d be making a lot more in a compound interest situation.
What we discussed above is why compound interest is used in investments. It continues to build and build upon what is in there, rather than what you started with.
Now, say that I invest $1,000 in a CD with 5% compound interest. So after the first year, I’d have $1050. Instead of having $1,100 by the end of the second year if it were simple interest, I’d have $1102.50. Now, sure, it’s $2.50, but by the end of 5 years I’d have $1276. Over time, the amount of interest I’d earn would be significantly more.
A number of retirement accounts, including IRA’s and 401k’s, use compound interest as their model. This allows individuals to accrue a lot of money over time. That’s why experts suggest that you start working on your retirement ASAP – the longer that money is in there, the more compound interest that you’ll end up earning.
But, as you could see, that’s why a lot of loans don’t use the compound principle. If they based it off of the principle of compound interest, they would end up losing money. For example, if I had that same $1,000 loan that I mentioned earlier, and paid off $500 of it, the next year they would only get an extra $25 for the following year.
Learn the Type of Interest Being Applied
Different companies are going to use different types of interest for different tasks, so it’s really important to learn how to read the fine print in loan contracts.
You want to understand every level of the process, including Annual Percentage Rate (APR), whether the interest rate is fixed or variable, and the payment and amortization schedules. If you understand all of those details, you should be able to determine what type of interest is being applied to your loan.
Most people don’t understand what they’re getting into when they look at potentially investing or getting out a loan. Always be sure to read what you are signing carefully and understand fully how the interest works on your payday loan or investment. Ask questions if you need to.
Before you take any sort of step toward signing for a loan, you want to talk to professionals that you can trust and learn about how it can help to benefit you. In the end, you’ll find a loan that meets your needs perfect and doesn’t rip you off with the interest rates.