Here at Bitches Get Riches, we’re constantly extolling the virtues of compounding interest, which Albert Einstein, Mother Theresa, and Nelson Mandela all deemed 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 its dual nature with a healthy dose of hyperbole, shall we?
*Not intended to be a factual statement
What is interest?
Interest is essentially the cost of borrowing money from someone else.
When you borrow or lend a pile of money, the interest is usually calculated as a set percentage of the whole pile. The percentage and other terms vary depending on the situation and the kind of loan or investment. “Safe” loans usually have small interest rates, and riskier loans have larger ones.
If you borrow money from someone, you’ll be paying interest back to your lender. So let’s say you put a $100 purchase on a credit card with a 20% interest rate. You’d owe your bank $100 plus $20 in interest as a fee for loaning you that money.
If you loan someone money, you’ll be paid interest on top of your initial investment, which you then get to keep. If you put $100 in a savings account with a 3% interest rate, your bank will keep your $100 safe, but they’ll also do stuff with it that will help them generate money. When you’re ready for it back, they will give you your $100 and pay you $3 as a fee for lending them the money.
What is accrual?
Interest also does something called “accruing.” This is just a bit trickier, but here’s how it works.
The word “accrue” means to accumulate or grow. Basically it means: how often is the amount of interest paid being recalculated based on the actual amount of money left to repay?
Interest usually accrues on a set regular basis: daily, monthly, or annually. And although it may not seem like it, the “accrual schedule” can have a big impact on how much money you end up owing (if you’re borrowing money) or receiving back (if you’re investing money).
If you’re borrowing money, you want a less frequent accrual rate. Annual would be awesome.
But if you’re lending money, the more frequent, the better! A daily accrual rate would be amazing.
I know that sounds kinda murky. So let me walk you through with a simple example that’ll help it feel more real.
How big of a deal can the accrual schedule really be tho?
Let’s say you open a savings account at Piggy Bank. I, its jovial-yet-incompetent CEO, agree to pay you 3% interest every month for whatever is in that account.
So you put in $100 to start, and add $1 more every day. As the amount of money in your account slowly grows, when are we going to hit refresh on that interest rate?
If your interest accrues annually, it means your bank will only pay you 3% of what you put in at the beginning of the year. It checks the balance once per year, and won’t recalculate it for another 364 days. So it doesn’t matter how much money you added every day throughout the year. You’ll still end the year with only $3 in interest.
- 3% of $100 on January 1, which is $3.00
- (Same exact payment for all twelve months of the year)
- Total extra money earned that year = $36.00
If your interest accrues monthly, it’s a very different deal. The bank would check your balance and reset the number 12 times instead of just once. That would give you:
- 3% of $100 on January 1, which is $3.00
- 3% of $131 on February 1, which is ~$4.00
- 3% of $159 on March 1, which is ~$4.75
- (And so on every month of the year)
- Total extra money earned that year = ~$96.00
Amazing, right? You’re earning almost three times as much money just by having what fancy folk would call “a more favorable accrual schedule!” It would be even more money if it accrued weekly or daily. That’s why lenders like frequent rates and borrowers prefer infrequent rates.
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 actually lending money. Usually to a business, who will use your money to invest in whatever they need to make more money.
When you invest, you’re basically setting your money up to earn 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.
You get to keep all the interest your invested money accrues. And to revisit that Eighth Wonder of the World, the law of compounding interest, the extra money you earn is based on the initial investment plus everything 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, whatever. 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 it 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 extra money you’ll have to pay because it’s a percentage of the whole, not a set dollar amount.
The bad news is that you’ll be paying more in the long run.
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 extra money 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.
Speaking of paying off debt:
- Share My Horror at the World’s Worst Debt Visualization
- A Dungeonmaster’s Guide to Defeating Debt
- The Best Way To Pay off Credit Card Debt: From the Snowball To the Avalanche
- The Debt-Killing Power of Rounding up Bills
- Investing Deathmatch: Paying off Debt vs. Investing in the Stock Market
The ultimate secret to harnessing interest
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. 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. It makes me feel like I’m getting one over on the lender! They made a deal with me expecting a hefty financial return. 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.
Too long; didn’t read?
Interest is the cost of using other people’s money. If you have money to lend, it’s your best friend because it multiplies your investments. But if you’re the one borrowing, it’s your worst enemy. It gobbles up a big portion of your minimum payments to prolong its life, like a boss casting healing spells on itself. The best way to kill high-interest debt is to pay more than the minimum. Even a little extra makes a huge impact over time.
This article is an update of one that was originally published on March 7, 2016.
8 thoughts to “Dafuq Is Interest? And How Does It Work for the Forces of Darkness?”
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Hurray!!! Welcome to Bitch Nation. Your citizenship comes with a beer and Newman’s Own knockoff Oreo cookies.
How does the concept of compound interest apply to something like an index fund? (Or does it?) People are always using compound interest calculators to predict future returns on investment accounts, but index funds and similar accounts don’t accrue, right?
Great post, thanks! I had heard of actual before but didn’t realize that you can benefit from a slow accrual schedule on your loans. Cool beans!
Quotation. How do you evaluate the benefit of paying off your loans early on your low-interest loans (car, mortgage, etc) vs socking away more money for retirement which is more tax efficient and, assuming historical returns for a moment here, likely to garner you higher interest than your loan? I know a lot of folks are against debt no matter what, but I don’t feel the same way. (I’m referring to after you have an emergency fund, naturally. Our mortgage is already refinanced down to 15 years with an amazingly low rate and we only carry a balance on 0% APR credit cards or else pay in full every month. No school loans either- overseas tuition rocks.) My intuition is always to sock away, in part because your fixed rate loan payment is effectively going down in real dollars over the life of the loan if there is even a modicum of inflation. Am I totally off base here? Missing anything?
Omg phone autocomplete…