“Interest” comes up a lot in personal finance. It’s a part of savings accounts, CDs, mortgages, and small loans. The better you understand how it works, the better you’ll be able to manage your money, make it work harder for you, and spend it wisely.
You’ll come across interest in two different ways: there’s interest that makes you money and interest that costs you money.
Interest that makes you money is interest you earn on a Savings Account, for example. Banks use money you deposit in a savings account to make investments. They earn a profit from those investments and share a portion of it with you. How much you get depends on how much you have in your Savings Account. Interest is always expressed as a percentage. So, if a Savings Account has 2% interest, a person will earn 2% of what they have deposited, per year.
The thing is, while the “interest rate” is an annual percentage, the interest is calculated monthly or daily, not yearly. The way the interest is divided up over the year is a complicated mathematical equation. But the result is a pretty good deal for customers: compounded interest. You don’t just earn a flat amount based on what’s in your account for the year. Instead, you earn interest on what you deposit, plus what you’ve earned from the bank, each period. It’s called compounded interest because the money literally compounds on top of itself-- it grows over a month, and then grows on top of what grew.
Interest that costs you money is the interest charged on loans (including mortgages) and overdue bills. The interest rate for mortgages (which are really just big loans for houses), is set by the federal government. It can fluctuate quite a bit depending on how the economy is doing.
The interest you pay on overdue bills, specifically credit cards, can be very, very high and therefore very, very expensive:
Let’s say you buy something for $500. Your credit card interest rate is 20% -- high, but not as high as some cards. You can only afford to pay $50 a month. That means it will take you almost 3 years to pay off what you bought and it will wind up costing you an extra $200 in interest charges. Keeping debt on your credit cards is also going to hurt your credit score which can make it more difficult to get a cell phone, buy a car, or purchase a house in the future.
That’s why it’s so important to pay off your credit card bills every month. Buy more than you can afford, and it can cost you big and for a very long time. Pay off your credit card bills on time, and worrying about interest charges (and how they work) is a thing of the past.