Breaking Down Interest—Considerations for Investments and Loans
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Interest. What a funny name for something many REALLY don’t find interesting. In fact, your eyes may already be glazing over just thinking about it. However, it’s time to start taking an interest in it and paying closer attention to how it can make or break our finances. Interest is the cost of borrowing money. If you take out a loan, you pay interest; if you lend money (or invest), you earn it. Here’s a quick interest breakdown to help you make smart financial moves.
Simple interest is the amount accrued on a principal balance (the original amount deposited or borrowed).
For example, you place $5,000 in an investment account. After a month, you’ve earned $5 in interest. The next month, you will still only earn interest on the $5,000 (the principal), not the $5,005 that you now have. The same applies to loans. Interest accrues on the amount you borrowed, not the amount of money you owe plus any interest that has accumulated. Simple interest is favorable when you’re borrowing money, and not so much when you’re investing.
Compound interest is the money accumulated on the principal balance PLUS the interest it’s already accrued.
Using the same example as above, if you invested $5,000, and earned $5 of interest in one month, you would now begin earning interest on $5,005 the next month. On the flip side, if you have a loan with compounding interest, the amount you owe can build up quicker with the loan balance accruing interest on interest. Compound interest is your friend when it comes to investments, not loans.
Let's talk about terms—the length of a loan or investment.
The amount of interest might not total much each month, but if the term of a loan or investment is several years, the interest can be significant. For example, the typical home-loan term is 30 years. The total interest on a loan for that long can add up to hundreds of thousands of dollars. Also consider how frequently the interest is calculated. Is it monthly? Quarterly? Annually? Have a grasp on these things before taking out a loan or making any investment.
Taking the type of interest, the rate, and the term into consideration is of the utmost importance because it can have a large impact on our bottom line. The easiest way to determine how interest will impact an investment or loan is by using an online calculator. This tool will quickly help you determine worthwhile investments and plan for the future. And if you’re hankering for a challenge, here's a link to the simple and compound interest formulas so you can calculate them on your own (what else were you going to do this weekend?). While the idea of interest might not be appealing, saving and making more money is never dull. We hope this helps in those endeavors.
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