Do you know how much interest you pay each month? I didn’t. I knew we paid interest, but I never really thought about the total or the ultimate impact it had on us until recently. Interest is the cost of borrowing money. When you have a loan or a credit card, you have to pay back the original amount plus any interest that has accumulated. But how much interest will there be? How is it calculated? How does it accumulate so fast?
Did you know there are different types of interest and different methods of calculating interest? Yeah. Most of us just think about our monthly payment. You could have a fixed interest rate or a variable interest rate. Your interest could be simple interest or compounding interest. Have I lost you yet? Don’t worry, it’s not as bad as it sounds.
What is a fixed interest rate?
A fixed interest rate is a rate that stays the same for the entire life of the loan. This is common with automobile loans. A fixed interest rate is good for planning purposes, but the rate might be slightly higher than an intro variable rate.
What is a variable interest rate?
A variable interest rate is one that can change throughout the life of the loan. The rate is based on fluctuating rates in the banking system, such as the prime rate. Because you (the borrower) are sharing the risk with the bank (the lender), the initial interest rate is often lower. Your loan should explain when the rate may change and how the rate is calculated.
Although variable interest rates aren’t all bad, you should approach them with caution. Make sure you understand the terms. If a rate increase will wreck your budget, this might not be the best option for you. If you have wiggle room in your budget, you COULD save money with a variable rate. It all depends on your unique situation and the terms of the loan.
What is simple interest?
Simple interest is calculated using only the principal balance of the loan. It is often found on installment loans and is pretty straightforward. Simple interest is calculated by multiplying the loan amount by the interest rate by the length of time. A $5000 loan with a 10% annual interest rate and a 1 year term would result in $500 interest. ($5,000 loan * 10% * 1 year = $500)
Usually the interest rate is listed as an annual percentage rate (APR), so that calculation would tell you the cost of the interest for ONE year. If you have a 5 year loan, you’d have to multiply that figure by 5 to find out the cost of interest for the life of the loan.
To figure out your monthly interest payment, you multiply the daily interest rate (APR/365) by the principal amount and by the number of days since your last payment. Usually your monthly interest amount will vary slightly because you are not always making your payments exactly 30 days apart.
What is amortization?
In simple terms, amortization just means paying off an amount owed over time. With an amortizing loan, the principal is paid down over the life of the loan through equal payments. Many auto loans and most mortgages use amortization.
For loans that use amortization, a portion of each payment goes to interest and a portion goes to principal. More money goes towards interest at the beginning of your loan term because the balance used to calculate interest is higher. As your balance decreases, you pay less interest and more of your payment will go to principal. This is great for us as borrowers because it saves interest costs in the long run.
Consider an auto loan that is $20,000 financed at 3% for 5 years. If simple interest was used, the total interest would be $3,000 ($20,000 * 3% * 5). With amortization, the total interest is only $1,562.43.
Amortization calculations are really complicated, but you can see the formula on Wikipedia if you really want to. I used the formula just to understand how the calculators work. Trust me on this…use a calculator. Your time is too valuable to do it by hand!
You can use my amortization calculator online through Google Sheets for free! You just need a Google account. When you click the link, it will prompt you to make your own copy so you can input your own figures! Below is a preview of what the sheet looks like.
What is compound interest?
Compound interest is calculated using the principal balance of the loan PLUS any outstanding interest. With compounding interest, you are not just paying interest on the amount of the loan. You are also paying interest on interest! Is that crazy or what? The ultimate cost of compounding interest depends on the type of loan and when the interest compounds.
Compound interest is what makes credit cards especially dangerous. You should read the fine print on your own card for exact details, but most cards compound daily. Compounding daily means interest is added to your balance every day and you pay interest on a higher balance each day.
Check out this example to see how it works:
As you can see, the balance increases every day. The interest charged also increases every day because it is being calculated on a higher balance. This compounding can make it so hard to get a credit card paid off. If you can only make the minimum payment, you may not even cover the interest charges. In some cases, this could mean you make a payment every month and your balance still goes up instead of down!
The good news is that you can use your credit cards for cash back benefits and avoid this interest by paying your card in full every month. This may not be true for cash advances or balance transfers. Be sure to check your card terms for details.
The bottom line is that it is really important to know your loan or credit card terms and interest rates. You could be paying HUNDREDS of dollars each month in interest (like us) without even realizing it! We all work hard for our money! We should be able to use it for things that are important to us, but that’s hard to do when a ton of money is going to interest each month.
Do you know your interest rates? Do you know how much you pay in interest each month? Check it out! If it makes you mad, that’s good motivation to pay off your debt.