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 fourth 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. Previous articles covered interest paid on money borrowed from banks or lenders and interest earned on money invested. This article will examine the importance of relative interest analysis and how the careful scrutiny of options can be useful to successful financial management.
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Analyzing Relative Interest
Suppose you owe $100 to a bank, and your annual interest rate on the loan is 5%. Normally, it is a good idea to pay off debts that carry interest because the longer a debt remains unpaid, the more expensive it ends up being at the end of the day. In other words, more time equals more interest charged, so a policy of paying off your debts as quickly as possible is usually a good rule to follow.
But if you want to be financially savvy, look at potential investment options before paying off the loan and how the potential interest earned compares with the interest being charged toward the loan.
Imagine that you have $100 borrowed from the bank, and you’re ready to repay the loan in full right now. That would prevent any future interest from being charged.
But before doing that, it’s advisable to ask, “How much interest could I earn if I invested this $100 rather than pay it back right away?” You know you’re going to be charged about $5 per year in interest (ignoring variations in compounding intervals) on that loan.
So if you could manage to make more than $5 in interest earned through an investment, then you’ll end up ahead financially. But if you can’t make more than $5, then investing doesn’t make sense.
If the $100 was invested in an ordinary interest-bearing bank account or CD, you may not find any investment vehicles that would provide a sufficient rate of interest. Secured loans rarely earn an interest rate as high as 5%.
For instance, imagine that you put that $100 in a CD that earns 2% annually. At the end of the first year, you’ll earn $2 in interest, but you would then have to pay the lender the $5 in interest on the money invested. In the end, you lose $3, which doesn’t make any financial sense at all.
But with investing in other options, like stock market index funds or real estate, there is a better chance of beating the 5% interest rate on the money you owe. With a $100 investment in mutual funds and an 8% expected rate of return, for example, the investment would show a profit of $8 in the first year.
After paying the lender the $5 owed in interest on the loan, the remaining profit is $3. That is $3 more than you would have had if you had simply paid the loan off immediately. This is why interest analysis matters.
But of course, it’s not always as simple as dollars and cents. Risk tolerance is another important factor to consider when you’re investing. For example, investing in unsecured mutual funds could mean that if an economic crisis suddenly emerged and the market crashed, you could lose some — maybe even all — of your money.
The chances of that happening are fairly low, but they aren’t zero. So ask yourself: Could you afford to weather that loss? Do you have enough financial resources in reserve such that you can endure setbacks? If the answer is no, then paying off the loan immediately might be a better option than investments, simply for reasons of financial security.
A solid understanding of interest principles is critical, since many of the more complex financial topics yet to be covered in this series will rely heavily on your ability to compute, analyze, and compare interest and return rates.
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 Wallace E. Boston 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 Wallace E. Boston 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.