Here at Bitches Get Riches, we’re constantly extolling the virtues of the law of compounding interest, which Albert Einstein, Mother Theresa, and Nelson Mandela all coined the Eighth Wonder of the World.* This might lead personal finance novices to believe that interest is universally a great and wealth-building thing. Not so, dear readers. Not so. Just as interest can work for you, contributing mightily to your financial goals over a long period of time, so it can spell your very doom. DOOM.
Like a monetary Dr. Jekyll and Mr. Hyde, interest has both your best interests (see what I did there?) and your utter financial destruction at its heart. Let’s explore the dual nature of interest with a healthy dose of hyperbole, shall we?
*Not intended to be a factual statement
What interest is
Interest is a small percentage of the original total which can be deducted from or applied to the original total incrementally over time. If you borrow money, you’ll be paying interest back to your lender. If you invest money, you’ll be paid interest on top of your initial investment which you then get to keep. Interest can accrue on an annual basis, and the percentage and other terms vary depending on the situation and the kind of loan or investment.
The good kind of interest
When you make a financial investment—contributing to your 401k, or a high yield online savings account, for example—you’re basically setting your money up to earn more money so you don’t have to. I revel in the idea that my hard-earned dollars are working for me like good little minions while I do… literally whatever the hell else I want to do.
When you invest your money, it can accrue, or gather, interest—other money on top of what you initially invested—which you then get to keep. And to revisit that Eighth Wonder of the World, the Law of Compounding Interest, the interest your money earns is based on the initial investment plus all the interest you’ve earned so far. So while the amount you originally set aside and the interest rate stay the same, the dollar amount of the earned interest constantly, steadily, beautifully rises like a goddamn hot air balloon of rapidly approaching financial independence.
The bad kind of interest
Sometimes if you don’t have enough money on hand to buy a thing—a house, a car, an education, groceries—you can borrow it from a bank or other large financial institution.
But these giant soulless corporations aren’t just going to give you the money you need for the thing. They’re not even going to wait patiently for you to pay back the amount you borrowed when you’re good and ready.
No, they’re going to require you to pay back the loan on a schedule, and they’re going to charge you interest while they’re at it. After all, they need to make the risk of lending to you worthwhile, and make up for the fact that while you’re using their money, they can’t. Think of interest as paying for the privilege of using someone else’s money.
The amount of interest they charge you is a percentage of the total you have left to pay off. It’s baked directly into your monthly minimum payment amount. So every month, part of your payment goes to pay back the original loan amount, but another part of it is that sweet, sweet interest going to line the coffers of your lender.
The good news is that as you pay off the loan, it will accrue less interest. In other words, the less money you owe, the less interest you’ll have to pay because the interest is a percentage of the whole, not a set dollar amount.
The bad news is that you’ll be paying more for a thing if you need to borrow money to buy that thing than if you had the cash on hand to buy it outright.
Speaking of paying off debt:
- Share My Horror: The World’s Worst Debt Visualization
- A Dungeonmaster’s Guide to Defeating Debt
- The “Best” Way to Pay off Credit Card Debt
- The Debt-Killing Power of Rounding Up
- Investing Deathmatch: Paying off Debt vs. Investing in the Stock Market
How to avoid the bad kind of interest
If you really need to borrow money but now you’re scared of the bad kind of interest, don’t fret! For there are ways to lessen the pain of paying interest on a loan.
You should start by doing your research. Not all loans offer the same terms, and you may find by shopping around that one lender has a lower interest rate than another. You might also find that a loan with a higher interest rate over a shorter period of time will save you more money than a lower interest rate over a longer period of time. So get mathy with it and don’t just take the first loan you’re offered.
The next step would be to put down as much money as you reasonably can as the down payment. The less money you’re borrowing, the less interest it will accrue. So while that down payment may feel expensive right now, it’ll save you money over the life of the loan.
Once you’re locked into a loan, there’s one more glorious way to save money on interest. You can pay more than the required monthly minimum.
I know, right? This is the tactic I employed when paying off my student loans, and it saved me thousands of dollars in interest. Again, because the interest is a percentage of the remaining whole and not a fixed amount, the interest payment goes down as you pay off the loan. So the more you pay off, the less interest you’ll have to pay, and the faster you’ll be free of the debt.
I really like paying off loans ahead of schedule because it makes me feel like I’m getting one over on the lender. They made a deal with me expecting a hefty financial return, and through completely legal and above-board means I’m cheating them out of a big chunk of change. In any financial deal, I want to get the upper hand. So paying my loans off quickly gives me all kinds of warm fuzzies with the added bonus of making me feel like an evil genius.
Interest: if you have money it helps you. If you owe money it fucking hurts.