Everything you need to know about interest rates

What is interest?

Simply put, interest is the “rent” paid for using someone else’s money. When you rent a car or an apartment, you don’t own that car or apartment, someone else does. You pay rent for the right to use that property for a certain period. 

When you borrow money, you pay “rent” to the person the money belongs to for the privilege of using their money. That special rent is what is known as interest.

In the same way, when you deposit money in a bank, the bank gets to use your money to make loans and investments. For the right to use your money, that bank pays you interest.

The components of a loan

Interest is usually discussed as a percentage of the amount you borrow or lend for a certain period. The actual amount you borrow or lend is called the “principal.”

The rates people and institutions charge to borrow money are determined by many factors: economic growth, inflation, riskiness of the borrower to the lender, government policies, and people’s confidence about the future.

What are simple and
compound interest?

There are two basic types of interest, simple and compound. Simple is calculated only on the principal, and compound is calculated on both principal and interest already earned. The example above illustrates simple interest – after one year you earn $4, so you have a total of $104.

With simple interest, you would earn another $4 in the second year for $108. With compound interest, you would earn 4% of $104 in year 2, bringing your balance to $108.16. Now, sixteen cents don’t seem like very much to get excited about but imagine if your principal was $1,000 or $10,000. We’re talking real money here.

Considering time and money

So clearly, interest, time, and money have a very complex relationship. This relationship is called the Time Value of Money (TVM), a concept at the heart of personal finance. Like many topics in finance, this Time Value of Money thing sounds quite complex, but in reality, it’s pretty simple.

It goes like this: $100 today is worth more than $100 in the future. It sounds paradoxical, but it’s logical. If I have $100 today, I can invest it and earn interest. Like in the earlier example, my $100 today will be worth $104 in one year. If you give me $100 in a year, it will be worth $100, no more and no less. 

Making interest your ally

We all will earn and pay interest at different times of our lives, and often we are both earning and paying at the same time. When you understand the relative amounts of interest, you can make the best choices for your situation, and isn’t personal finance all about the choices we make?

For example, people often ask, “should I put my extra money into savings or pay down my credit card balance?” Assuming you have enough on hand to pay for emergencies, you’re usually better off paying down your credit card.

Credit cards charge, on average, over 20% per year interest, compared to savings accounts paying 2% or 3% and money market accounts paying 4%. If you put your extra $500 into a money market account, you will earn $20 in a year. If you pay down your credit card balance, you will have paid $100 less interest in a year. Remember, this assumes you have those emergency funds! Not paying interest to the bank is the same as earning it.

Here’s another example

Should I pay $1,000 on my credit card balance, or should I put that money into my 401(k) account?

We know that credit cards charge 20% or more each year, and investments grow, on average 7% or 8% a year, so paying off the credit card seems smart, right? But many employers offer matching deposits to 401(k) accounts which can be 25% to 50% of the amount you deposit. So, if you can get an extra 50% from your employer, plus 7% earnings on your deposit, then the 401(k) is clearly the better choice.

Of course, the right moves depend on your specific needs and circumstances, so consult a professional before making any big decisions with your money.

Final thoughts

In the end, interest is not inherently good or bad. Interest is just a measure of the price to borrow or lend money. Once you understand interest and the Time Value of Money, you have the tools to make the best choices for your situation. And remember, not paying interest to the credit card company is just as valuable as earning interest on your savings and investments!

Post Disclaimer

Julep is not a financial institution, financial advisor, or credit repair company, and does not provide credit repair services of any kind. The information provided is for general educational and reference purposes only. The information is not intended to provide legal, tax, or financial advice. We do not propose any guarantee that the information provided will repair or improve your financial profile. Consult the services of a competent licensed professional when You need financial assistance.

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