The Significance of Interest
We all know that interest is the cost to borrow money but how much consideration do we really give it when it comes time to sign on the dotted line? A critical aspect to managing our debt is to first thoroughly understand how interest rates are charged and to be able to calculate your payments once interest is factored in.
Interest rates generally break down into three methods:
Simple Interest Rate, Periodic Interest Rate, and Compounded Interest Rate
Simple Interest Rate is commonly known as an annual percentage rate. A simple example of Simple IR would look like this:
Say you borrow $10,000 at 10% interest. You would be paying $1000 annually in interest using this model.
Periodic Interest Rate is a similar calculation but comes into play when considering a loan period less than a year. In this case you would again take the annual percentage rate and divide it by the number of periods. Periods in this case could be months, biweekly payments, weeks, etc.
Compounded Interest Rate in its simplest form charges interest on the interest. As a result a borrower will pay a higher compounded rate then a similar loan with a simple interest rate.
A useful Compound Interest Rate calculator can be found at the following:
Moneychimp
Keeping an eye on interest rates is a valuable decision-making tool which indicates when to borrow and when to invest. When interest rates begin to drop, it is a good time to borrow. Whereas periods of rising rates could mean a higher return by investing in money market accounts, mutual funds, and CDs. Remember that these kinds of investments will earn a higher rate of return when interest rates are rising.
