By: Charlestien Harris
When I think about the month of February, love or having a “love interest” comes to mind. It’s the month that celebrates love and what it means to be loved by someone. Now, you might ask, how is the topic of interest tied to love? But, if you look carefully, I have put a slight spin on the meaning of “love interest.” Interest in the financial world is defined as a payment from a borrower or deposit-taking financial institution to a lender or depositor, of an amount above repayment of the principal sum at a particular rate. There are several different types of interest payments – some you may be familiar with, and others you may not. In this article, I hope to create a “little interest” in the different types of interest and how they can affect your bottom line when it comes to making money on your money or owing more money.
Below are some common types of interest and their definitions.
- Simple interest is an interest charge that borrowers pay lenders for a loan. It is also the type of interest that banks pay customers on their savings accounts. Simple interest is calculated by multiplying the loan principal by the interest rate and then by the term of a loan. Simple interest can provide borrowers with a general idea of how much it will cost to borrow money. It involves no calculation of compound interest. Auto loans and short-term personal loans are usually simple interest loans.
- Compound interest, in simple terms, can be defined as interest you earn on interest. Compound interest causes your wealth to grow faster, making a sum of money grow at a faster rate than simple interest. It allows you to earn returns on the money you invest, as well as on returns at the end of every compounding period. This means that you don’t have to put away as much money to reach your goals. Also, you will earn money on the principal amount in your account and interest on the accrued interest you’ve already earned.
- Annual Percentage Rate interest, or better known as APR, is the total cost of a loan, including both the interest rate and any other associated fees. APR is the interest rate charged by a lender on a yearly basis, expressed in the form of a percentage. It is usually displayed as a percentage and is charged annually. APR is calculated by multiplying the periodic interest rate by the number of periods in a year in which it was applied. It does not indicate how many times the rate is actually applied to the balance.
- Accrued interest is unpaid interest related to credit cards, loans, investments, savings, and other financial transactions. In personal finance, accrued interest can be owed or earned. Accrued interest on a loan or credit card adds to how much a borrower owes. Accrued interest on a savings account or an investment earns income. It is calculated by multiplying the outstanding balance of a loan by the interest rate. This is then compounded on a daily or monthly basis, increasing the total amount owed and added to the principal balance of the loan.
- Fixed interest rate is an unchanging interest rate charged on a liability, such as a loan or a mortgage. It might apply during the entire term of the loan or for just part of the term, but it remains the same throughout a set period. The calculation of a fixed interest rate is straightforward, requiring only the principal amount (the borrowed amount), interest rate, and the length of time of the borrowed money. The formula includes the principal multiplied by the rate of interest multiplied by the length of time.
- Variable interest rate is a type of interest charged on the outstanding balance of a loan that fluctuates based on an underlying market interest rate or an interest index that periodically changes. A variable rate loan benefits borrowers in a declining interest rate market because their loan payments will decrease. However, when interest rates rise, borrowers with a variable rate loan will find the amount due on their loan payments increasing. In the housing market, this is known as an Adjustable-Rate Mortgage or (ARM). An ARM might be a good fit for a borrower who plans to sell their home after a few years or one who plans to refinance in the short term. The longer you plan to have the mortgage, the riskier an ARM will be because there is always a chance that the interest rate will climb higher during the life of the loan.
I hope I stirred up a little “love interest” in your quest to learn more about how interest is calculated and the many different types of interest commonly used in the world of finance. Arming yourself with the proper knowledge of how interest works and how much interest you will be paying on a loan can help you achieve those financial goals you may have set at the beginning of the year!
Until next week – stay financially fit!