Get interested in “getting” interest
August 13th, 2007 | by rachel |
Are you one of those people that is not interested in interest? If so, you might want to get interested. Not just in earning interest but in “getting” (understanding) it also! Whether you realize it or not, you have an interest in interest. It affects your mortgage, your car loan, your unsecured debt and your investments. Interest affects your cash flow and, thus, your daily life. The concept of interest is not a difficult one to understand. The application of that concept can be. The information here will help make sure that you really get interested in “getting” interest and how it affects your finances.
DEFINITIONS:
interest = the cost of borrowing money
principal = the amount of money being borrowed
interest rate = the % of principal that must be paid for the privilege of borrowing the money
Where interest is concerned, it’s important to realize that it is viewed from 2 VERY DIFFERENT perspectives. A lender makes the actual loan and profits from higher interest rates paid over long periods of time. A borrower can minimize the cost of borrowing with lower interest rates and by paying off the loan sooner rather than later. It is possible to be a borrower and a lender at the same time. You are a borrower if you have an outstanding mortgage, car loan and/or credit card balance. You are a lender if you have a savings account, certificate of deposit and/or other investment accounts.
No matter which role you are in (borrower or lender), there are only 2 types of interest. Simple Interest is interest that is calculated only on the amount of principal. Compound Interest is interest that is calculated on the amount of principal AND any interest earned or owed. Compound interest allows a lender to increase their earnings exponentially and build wealth quicker than with simple interest. While compound interest is a good thing for lenders, it has the potential to be a bad thing for borrowers. At the same time lenders are expanding their earnings, borrowers are paying more when interest is compunded on debt they owe.
In order to fully understand interest, you need to know how interest is calculated…
SIMPLE INTEREST = principal x rate x time
For example, if you opened a savings account with $650 at an interest rate of 4.93% for 1 year, that account would earn $32 of interest.
Compound interest is more difficult to calculate because it involves more variables than simple interest. The reason that compound interest increases wealth more quickly than simple interest is that it calculates and credits interest more often than simple interest. The more often the interest is compounded, the more money there is to apply the interest rate to.
After you understand the concept of interest, you need to take some time to apply it to your own finances. To do that effectively, answer these questions:
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What financial accounts do I have where I am the BORROWER? What are the balances owed and the interest rates being charged on those accounts?
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What financial accounts do I have where I am the LENDER? What are the current balances and interest rates being earned on those accounts?
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How is interest being calculated on my accounts? (simple or compound)
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If interest is being compounded, how often is it being compounded?
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Are there debts that I can pay off in order to have more money to put in accounts that are earning interest? If so, what are they and how quickly can I pay them off?
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Am I contributing to retirement accounts that are available to me? If so, what are the balances and interest rates for those accounts? How and when is the interest rate calculated for those accounts?
For more information about interest, visit these sites:
www.thecompoundinterestcalculator.com