By Dr. Gary L. Deel
Faculty Director, Wallace E. Boston School of Business
and Dr. Karin Ford-Torres
Faculty Member, Wallace E. Boston School of Business
This is the second article in an ongoing series on sound tips for financial security and prosperity. Nothing in these articles is intended as formal legal or financial advice. Readers should consult with an attorney or licensed financial advisor before making any financial decisions.
In this installment of the Smart Personal Finance 101 series, we’re covering interest. Are you interested? (See what we did there?!)
Understanding interest is absolutely critical to sound financial management. There are two primary types of interest: interest you pay on money owed and interest you earn on money invested.
Learn more about the online B.S. in accounting at American Public University.
What Is Interest Paid on Money Owed?
The first category, interest paid on money owed, is fairly straightforward. Say you borrow $100 from a bank or lender. If your interest rate is 10%, then you should expect that borrowing that money will cost you $10 in interest per period.
But wait! What’s a period? The period is the amount of time for which the interest rate is quoted. Interest rates are most often expressed in annual terms, commonly referred to as annual percentage rates or APRs. So if the interest is 10% annually on a $100 loan, then you can expect to pay $10 for every year that the $100 is unpaid.
But unfortunately, it gets a bit more complex than that. You also need to consider the difference between simple and compound interest.
Why the Difference Between Simple and Compound Interest Matters
With simple interest, the interest is charged only against the principal balance of the loan — the original amount that you borrowed. For example, if you borrow $100 at 10% simple interest and make no payments, you would accrue $10 in interest the first year. In the second year, your balance would obviously be $110, but the interest is still only charged against the principal balance of $100.
The $10 in prior interest charges is not counted when the next interest charges are applied. So with simple interest loans, interest is never applied against previous interest charges on the loan. Most auto loans and mortgages operate using a simple interest model.
But what about compounding interest? That is when prior interest charges are counted for the purposes of future calculations.
Using the previous example, the interest in the second year would be calculated against the full outstanding balance of $110 (principal + interest) and not just the $100 principal. Credit cards and some student loans and payday loans use the compounding interest model.
Why does this difference matter? The answer is compounding intervals. In other words, if you have a compound interest debt, you need to pay attention to how often the interest is being calculated and applied to the total balance of the loan. The more frequently interest is compounded, the more expensive the loan is.
If interest were compounded annually (i.e., one time per year), then the math is simple. Take your $100 loan and add interest of 10% per year. That means at the end of the first year of the loan, your total balance should increase to $110 if you haven’t made any payments against it.
But most interest is not compounded annually. The most common compounding interval is monthly. So if you take that same $100 loan and apply a portion of the interest each month, the end is actually a greater expense for the borrower.
Here’s how it works. Take the 10% interest rate and divide it by 12 for the 12 months of the year. That gives you a monthly interest applied of 0.83%. After the first month of your loan ends, the interest of 0.83% is applied and the new loan balance becomes $100.83.
Over time, monthly compounding interest becomes more expensive. In the second month, the same interest — 0.83% — is applied to the loan.
But instead of being applied against the original principal of $100, it is now being applied against the principal and the first month’s interest — $100.83. This monthly compounding creates a snowball effect, whereby at the end of the first year, instead of having a total balance of $110, you would actually have a total balance of $110.47.
Now, 47 cents doesn’t sound like a lot, but remember that’s based on a loan of only $100 and it’s only for the first year of the loan. Imagine what the difference would be if, say, you bought an expensive house and carried the loan for 30 years. That 47 cents would become hundreds or even thousands of dollars.
If you’re interested, use this handy compounding interest calculator to play with different amounts, interest rates, and intervals to see the effects of differences over time. But the larger point is that compounding intervals matter.
In the next article in this series, we’ll look at the other kind of interest: Interest earned on money invested.
The university offers academic programs in accounting and finance, which cover important financial discussions in depth. Readers who are considering expanding their knowledge and credentials in this field are encouraged to visit our program pages for more information.
About the Authors
Dr. Gary Deel is a Faculty Director with the School of Business at American Public University. He holds a J.D. in Law and a Ph.D. in Hospitality/Business Management. Gary teaches human resources and employment law classes for American Public University, the University of Central Florida, Colorado State University and others.
Dr. Karin Ford-Torres is an Associate Professor with the School of Business at American Public University. She holds a Ph.D. in Business Administration with a concentration in Advanced Accounting and Financial Management. Karin teaches accounting and finance courses for American Public University, Purdue University Global and Colorado State University-Global. She has 24 years of prior banking experience with Bank of America.