How Does Interest Work?
It has come to my attention, that interest as a whole is not very well explained in school or life. I was recently having a conversation with someone very close to me about mortgages. I was mentioning something regarding changing interest rates. “What? There is interest on a mortgage? Even if you pay it on time every month?”.
The conversation above has prompted this very dry, very long blog post. Enjoy!
What is interest?
To put it simply, interest is the cost of borrowing money. Interest is normally described as a percentage of the overall loan. Not only will you have to pay back the original amount you borrowed, but you will also have to pay back the cost of borrowing the money (the interest). How much interest you pay, and how it is calculated varies widely depending on your financial position, and the institution you borrow from.
Before we continue, I must make something very clear – interest is the cost of borrowing. Likewise, when you earn interest on deposits into your bank account, interest is still the cost of borrowing, just reversed. The bank is paying you for lending them money, instead of you paying the bank. Got it? Good.
Periodically, (usually every month or every quarter), the bank pays you interest on your savings. When interest is paid to you, you will see your balance go up. You can either spend that interest or save it. When you keep the interest in your account month-after-month, the savings start to add up because you are earning interest on the interest you already earned. This is called compound interest.
You deposit $100 into an account that pays 3% interest. Using the Simple Interest calculation, you would earn $3 in one year. To calculate:
100 X 0.03 = $3
However, most banks calculate interest daily, not annually. So, this works out in your favour because of compound interest. Your account balance would be $103.50. Your APY would be 3.05%. APY (Annual Percentage Yield) calculates how much you will earn on your compounded interest over the course of one year. If you leave the account alone, the next year you will earn $3.14.
The difference in our example is only $0.50, but we are only talking about $100. Imagine what the difference would be on a larger amount of money.
When you borrow money, you generally have to pay interest. Sometimes you might be paying interest, without actually knowing you are paying interest.
With installment loans such as a mortgage, auto, and student loan, the interest is packaged in with your payment. Every time you make your monthly (or bi-weekly) payment, a portion goes to the principal balance and a portion goes to interest. As the balance gets smaller, less of your payment goes to interest and more goes to principal. See the example below of a $20,000 loan charging 5% interest with monthly payments. This is called an amortization table.
Other loans are revolving loans, meaning you can borrow more month-after-month, providing you make periodic payments on the debt. For example, a credit card is a form of revolving debt. Credit cards allow you to spend continuously as long as you stay below your credit limit. Interest on credit cards is very sneaky, and we will save that for a separate post.
Different types of interest
Fixed Rate Interest – The interest rate remains constant over the life of the loan (or amortization period).
Variable Rate Interest – Variable rate loans allow the lender to adjust the interest rate on the loan according to market conditions. This type of interest can seem attractive when rates are low, but if you’re locked into a variable rate loan when interest rates rise, you will be in for a major payment shock.
APR – Annual Percentage Rate is the total cost of the loan based on a yearly metric. This calculation generally includes setup fees and administration costs. This number is generally higher than the initial “interest rate” lenders disclose. Make sure you know the APR of the loan you are considering.
Simple Interest – This formula is generally not used for calculating interest rates. Instead, we use the compound interest calculation. However, simple interest is calculated by multiplying the loan amount, by the interest rate, by the number of payment periods in the life of the loan.
Compound Interest – Compound interest relates to charges the borrower must pay not just on the principal amount borrowed, as in simple interest, but also on any interest outstanding at that point in time. To explain the difference between compounding interest and simple interest, consider the following scenario of a $1000 loan taken out at 10% over two years (assuming no monthly payments are made on the loan):
First year: $1,000 x 1 year x 10% = $100 in interest
Second year: $1,000 x 1 year x 10% = $100 in interest
Total Interest: $200
Total of the principal amount plus interest = $1,200
In this scenario, the total amount of interest paid over the life of the loan would be $200
First year: $1,000 x 1 year x 10% = $100 in interest
Second year: $1,100 ($1000 principal plus $100 accrued interest) x 1 year x 10% = $110 in interest
Total Interest: $210
Total of the principal amount plus interest = $1,210
In this scenario, with interest compounded annually, the total amount of interest paid is $210
I hope this helped to explain interest and how it is calculated. Please feel free to leave comments/questions below, and I will be happy to answer them.