Interest is simply the cost of borrowing money. A lender earns his living by charging interest. A borrower pays interest for using a sum of money that does not belong to him. Interest can cut both ways – high interest rates are good for savers but bad news for mortgage payments. Understanding how interest rates work and what they are can help you save significant amounts of money in the short and long run.
Types of interest
There are broadly two types of interest – simple and compound. Simple interest rate is a straight line percentage of the principal borrowed or invested. For example for a loan of $1,000 at an interest rate of 5% per annum, the interest is 5% times $1,000 or $50. The total amount due at the end of the loan term is $1,050.
Compound interest is a series of interest charges applied either daily, monthly or early. A loan of $1,000 at an interest rate of 5% per annum compounded monthly would result in an interest charge of $149, a significantly higher amount compared to simple interest. The difference is compound interest rates effectively charge interest on interest and the more frequently rates are compounded, the higher your interest charge will be.
Influence on Interest Rates
The central bank of most governments set a baseline interest rate. In the United States of America, this is the risk free rate of the US Government’s Treasury bill. This is the base which banks and other credit providers start their interest rates from, and therefore is the lowest possible interest rate on the market. The government can use interest rates to influence the economy, to encourage or stop the flow of money and to reduce the amount of credit available in the market. During the recent recession, governments the world over slashed interest rates in a bid to stimulate loans in their local money markets, a move designed to kickstart business activity.
Credit Card rates
Interest rates on credit cards are generally higher than on normal loans. The reason is interest rates on borrowings reflect the inherent risk of the loan. Without a guarantee against the line of credit afforded by a credit card, providers charge an exorbitantly high interest rate on credit card balances. Remember that if you do not pay your balances off every month, this high interest rate will be applied, and compounded daily. The best way to beat high compounding interest rates on your credit card is to pay your outstanding bill off in full every month.
Interest Rates on Savings
The interest rates on savings as advertised by banks can be misleading as they may be gross interest rates, that is, the flat rate of interest actually paid. For a savings account earning a monthly interest rate, the gross rate would be 4.89%. If the same account earned an annual interest rate, the gross rate would be 5%. Both accounts would earn identical interest if you left both the principal and the interest it earned in the bank for a year – the differences in rate simply demonstrates the effect of compound interest. Asking for a savings account with daily compounded interest rates mean your money will be earning more money faster than simple interest accounts.
Interest Rates on Loans
Borrowers have a choice when it comes to loans – you can fix or float your interest rates. This means that you can either fix an interest rate now based on current levels of interest, which will insulate you from any increases in rates in the future, or you can leave your borrowings to be charged at whatever the interest rate of the moment is. A floating rate will reduce your mortgage payments when interest rates fall, but also increase your interest charges should rates rise. Remember that interest rate is a changeable economic factor and will fluctuate depending on the economy and the government’s monetary policy. The best option is for a fixed and floating interest rate on loans, which hedges your bet both ways.