Compounding interest

Most people don’t think too much about interest rates. They know that they are a number and the know that a lower one is better than a higher one, but they don’t take the time to think about what they really mean, or what the impact of them is on your finances. Our loans and credit cards all have interest rates attached to them and a small difference in the rates can make a huge difference in the cost of the debt over its term.

First, it is probably important to understand what compound interest is exactly. The opposite of compound interest is simple interest. With simple interest if I started with $100 and an interest rate of 10% I would get $10 in interest after one year and an additional $10 for each year after that. Compound interest works differently. I would still get $10 the first year, so I would end the first year with a total of $110. The second year I would get 10% of that $110 or $11, leaving me with $121. The third year I would get 10% of that amount, leaving me with $133.10, and so on. So after three years with simple interest I would have $130, but with compound interest I have $3.10 more. Every loan and credit card is calculated using compound interest.

Compound-interest

To begin to understand the power of compounding interest, let’s take a look at two simple examples. Let’s we have a credit card balance of $10,000 at an interest rate of 8% and for some reason we don’t pay it for 5 years (This is, of course, a really bad idea). At the end of 5 years, the new balance would be $14,693. In other words we have built up an additional $4,693 in interest. Now let’s use the same example again, except for a 9% interest rate. This small change in interest rate makes the new balance $15,386, for a difference of $693 over the lower interest rate. That might not seem like much, but a mere 1% difference in interest rate over 5 years added an additional 7% to the original balance. That can really add up.

For a more extreme example, let’s compare 5% to 10% interest using the same example as above. 5% interest over 5 years would leave us with a balance of $12,763. Doubling the interest rate to 10% creates a balance of $16,105. Doubling the interest rate leads to considerably more than a doubling of interest.

By understanding interest rates and considering it when you are shopping for loans or credit cards you can save yourself literally thousands of dollars.