Get Yourself FinLit

Beginners Guide To Interest

Interest is basically the principle that when someone lends you money, you have to pay the money back, plus a little bit extra for the service of them lending it to you. On the other side of the coin, if you lend someone money, you can expect them to pay you back plus a little extra.

So when you find a little more money in your savings account every now and then, it’s because the bank has essentially borrowed your money, invested it, and given you a little bit of a bonus for banking with them. And if your credit card bill seems to be higher than the amount that you’ve spent, that may be because you’ve copped interest on the outstanding balance you’ve yet to pay back.

Why does it exist?

If there was no such thing as interest, there wouldn’t be too many people who’d want to lend you money. And chances are, you wouldn’t be too keen on lending away your hard earned cash for no gain. Interest allows people to borrow money to buy stuff they can’t afford immediately, like a car or a house. If you’ve got a big chunk of money, or you want to borrow a big chunk of money, you’ll want to shop around to find the best interest rate to match your needs.

Interest Rates

Interest rates are involved in almost any financial service a bank provides. If you’ve got a savings account, you’re probably earning interest. If you’re taking out a loan, you’re going to have to pay it back with interest. If you’ve got a credit card, you’ll be paying interest on the outstanding balance you haven’t paid back. All of these services will have varying interest rates depending on which bank or financial institution you’re with, which is why it is so important to shop around to find the service that’s right for your needs.

Interest rates are also constantly changing, based on a whole bunch of economic factors like overseas interest rates, or more personal factors like how ‘risky’ the lender considers the borrower to be.

Fixed and Variable Interest Rates

Interest rates on financial services such as loans can either be fixed or variable. Fixed interest rates stay the same over the span of time you have agreed to make repayments (called the ‘term’) meaning your repayments will stay the same. Meanwhile, variable interest rates change over time as the market changes, thus your repayments change along with them. When taking out a loan, it’s important to consider which kind of interest rate will benefit you most. If interest rates are low at the time you take out your loan, you may want to lock it in with a fixed rate. If interest rates are high but you they there might be about to decline, a variable rate might be the better option. It all depends on how much your repayments are and how long the term of your loan is.

How Interest Rates Work?

Basically, there’s simple interest and compound interest. Simple interest is, as the name suggests, pretty simple. Say you have $1000 in a savings account accruing 1% interest per annum for five years. At the end of the five years you’ll have $1050 – that’s $10 (or 1% of $1000) per year for five years.

The thing is though, most banks use compound interest, which means that each time the interest is paid (usually monthly), it’s paid on the accumulated total amount, rather than just the principal (or the initial) amount. So in the example above, the first month would pay $0.83 of interest, then the next month’s interest would be calculated on $1,000.83 (rather than just the original $1,000), and so on. After five years you’d have $1,051.25.

Basically, compound interest builds up slightly faster, both with profit and debt.

This information is intended to be general in nature only and might not apply to your personal circumstances. When in doubt always seek professional guidance.
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