FinLit #4 — Interest

In our previous posts, we were discussing loans, its reimbursement and the extra you have to pay back. That extra is called interest.
What is Interest?
Interest is the charge for the privilege of borrowing money. The interest rate is the amount charged, expressed as a percentage of principal (original loan amount) by the lender to the borrower. Interest has two main types associated with a loan: simple and compound. Typically interest rates are noted on an annual (12 month) basis, annual percentage rate (APR).
What is Simple interest?
Simple interest is determined by multiplying the principal (P) by the daily interest rate (I) by the number of days (N) that elapse between payments.
Simple Interest = P x I x N (You do not need to memorize, you can also come back to reference.)
When you make a payment on a simple interest loan, the payment first goes toward that month’s interest, and the remainder goes toward the principal. Each month’s interest is paid in full, so it never accrues.
Example: You have a loan that has a $15,000 principal balance and an annual 5% simple interest rate. If your payment is due on May 1 and you pay it precisely on the deadline, your interest is calculated on the 30 days in April. Your interest for 30 days is $61.64 under this scenario. However, if you make the payment on April 21, the finance company charges you interest for only for 20 days in April, dropping your interest payment to $41.09, a $20 savings.
What is Compound interest?
Compound interest is interest calculated on the original principal and also the accumulated interest of previous periods of a loan. Period is the duration of time. Periods could be days, months, quarters (every three months), semi-annual (every six months) or annual.
The higher the number of compound periods, the greater the compound interest. The interest amount is not the same over a period of time (as it would be with simple interest). Periods make a significant difference with compound interest!
Example: Take a five-year loan of $5,000 at an interest rate of 5% that compounds annually. What would be the amount of interest if you do not make a single payment. In this case it would be $,1381.40.
I know this because this is how you calculate compound interest:
Principal x [1+ i(interest rate)^n(number of years] -1. In this case, it would be: $5,000 [(1 + 0.05)⁵] — 1 = $5,000 [1.27628–1] = $1,381.40.
You can also come back here to reference as a guide or one of the other many compounding interest websites.
The basic rule is that the higher the number of compounding periods, the greater the amount of compound interest.
If you wanted to know what the interest rate is for a period of time, you can figure that out as well.
A periodic interest rate is an annual rate divided by the number of compounding periods. Compounds directly affect the periodic rate of a loan or investment.
Example: If the annual interest rate on a mortgage is 12%, the periodic interest rate used to calculate the interest assessed in any single month is 0.12 / 12 = 0.01 or 1%. This means that every month, the remaining principal balance of the mortgage loan has a 1% interest rate applied to it.
Why does any of this matter?
Learning about interest rates is a crucial component in personal finance and overall financial literacy. Interest rates determine how much money you will either pay out or recieve. If you cannot figure out how much you will eventually owe or eventually earn, you are putting yourself at a severe financial disadvantage. Knowing your debt and assets plays a pivotal role in creating financial stability.
Also, interest is a philosophy based on the time value of money (TVM). TVM is the idea that money available at present is worth more than the same amount in the future due to potentials earning capacity. You will use the compound interest formula to figure that out.
Question: You have 1,000. You could choose among, lending the money to a classmate, who promises to pay you back 1,100, this time next year, buy into a business that promises 3% growth quarter or leave the money in an account that guarantees 2% interest annually.
For the next year, which option would you choose? I shall leave this question for you to decide in the comments section, I will love to hear people's thoughts!
In our next post, we will dive into what affects interest rates as well as dive into the concept of money.
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