Interest – Cost Perspective

Why should you care about interest? Because it costs you money not to care. It is the basis of putting your money to work for you. Let’s begin by describing what interest is…

Interest is the price you pay to borrow money and it works the other way around where interest is the cost you charge to lend money.

The most basic principal to understand from that definition is that there is a price you pay to use your money. For example, if you are like many people you probably use your credit card for convenience. Its super easy to carry a plastic card with you than having to deal with hard currency. Nobody really wants to handle money anymore. You also must understand that when your statement finally comes around each of those purchases have already started to accrue interest. Usually there is no interest to pay if you pay down your month’s worth of credit card transactions when the payment is due. But what happens if you can’t pay down the debt in full? You pay interest and the interest you pay on your credit cards is near punitive. On average consumers pay 18.3% interest on their credit cards. Let’s unpack that

18.3% interest rate can mean different things depending on how the interest is calculated. Another term you will likely find is Annual Percentage Rate, or APR. This describes how much interest cost (or earnings) one would accrue over the year. It is required by law to be disclosed and is useful in comparing offers from lenders. While it does include fees or additional costs associated with the loan, it does not reflect the daily compounding of the interest. You might be wondering what daily compounding means.

Interest is calculated multiple ways. The easiest method of interest calculation is called Simple Interest meaning a borrower only pays on the principal balance. The formula is also simple, (i) represents the interest, (p) represents the original balance, and (r) equals the interest rate, and (t) equals time periods. Therefore i=p*r*t. On a $1,000 loan over 3 years at 5% interest will yield 1000*3*.05 or $150.

Very few lenders use the simple interest methodology and instead they use Compounding Interest. Compounding means that as interest accrues on the loan the next day the balance grows by the prior day’s accrued interest. The formula is more complex and requires the following parameters: (A) final amount, (P) initial principal balance, (r) interest rate, (n) number of times interest applied over a time period and finally (t) number of time periods elapsed. A great example is a 30 year mortgage, where t=30 years and n=12 months therefore a 30 year mortgage has 30*12 or 360 periods to apply interest rates.

Here is an example of a calculator that illustrates the difference in the cost between a simple and compounded interest loan.

Let’s return to the original discussion about credit cards. Using what we learned you can see that 18.3% on an unpaid credit card balance costs you money. Let’s assume that over the month you racked up $5000 in debt on your credit cards and you can only pay the minimum balance of $125/month. It will take you 6 years to pay off that debt and will cost you $2,777 in interest charges. What else could you have done with the $2,777 you spent for the privilege of instant gratification? Here is an example of the calculator so you can see for yourself the actual cost of borrowing money.

Tomorrow I’ll dig into Interest from an earnings perspective.