Tips about Interest Rates

 

Few who have take the time to sit down and add it the difference that interest rates make. After all, why would you bother, it’s all taken care of for you by the loan companies, and the government won’t let them rip you off, right? The answer is that understanding just how interest rates work can help you see how important small differences in rates and payment amounts can be.

 

1. Interest rates are compounded.

 

It is important to remember that what you owe is compounded – that means you pay interest on the interest you owe from the month before. That means that if you’re paying 2% per month in interest, you’re not paying 24% per year – you’re actually paying 26.82%. Charging interest monthly instead of yearly is a trick to make it feel like you are paying a very low price for your borrowing.

 

2. Which would you rather have?

 

Here’s a question: would you rather have $1 million or $10,000 in a savings account earning 20% per year in compound interest?

 

Well, let’s see how that $10,000 would grow. After 10 years: $61,917. 20 years: $383,375. 30 years: $2,373,763. 40 years: $91,004,381. 50 years: $563,475,143.

 

So after fifty years, you’d have over $500 million?! Well, not so fast. Of course, you have to take inflation into account – if we say inflation is 5%, then that money would have the buying power that $10,732,859 does today. Still, that’s not a bad return on your investment of $10,000, is it?

 

That’s the power of compound interest, and the way the credit card companies make their money (it’s also the way pensions work, and the reason the prices of things seem to rise massively as you get older). Be very, very afraid of compound interest. Or, of course, you could start saving some of your money instead of spending all you earn and more, and be very glad of it…

 

3. Compound interest adds up.

 

Let’s work through an example on a more real kind of scale. Let’s say you have an average unpaid balance of $1,000 on a card at 15% APR.

 

You will owe $150 in interest for the first year you borrow. However, this amount is then added onto the balance, and interest is charged on that. The second year, you’d owe another $172.50, for a total of $1322.50. It goes on, with totals like this: $1,520.88, $1,749, $2,011.35.

 

After just five years at 15%, you’d owe double what you borrowed. And after 10 years, you’d owe four times what you borrowed! Bet you weren’t expecting that. If you let something like that carry on for long enough, you’ll end up paying back that credit card for years afterwards, paying back what you borrowed many times over and still not