09 Dec The Joy of Giving
This time of year, it’s always a pleasure to be able to surprise friends and loved ones with the most coveted gifts and items on their wish lists. For some, this is not always feasible. Borrowing money, for most people, is a fact of life. Interest is the cost of borrowing money. Borrowers pay a fee for using the owner’s money. Usually, interest is calculated as a percentage of the amount of money borrowed, an interest rate.
When a borrower takes out a loan, the lender essentially purchases the item for you and allows you to pay back the money over a period of time. What’s happening here is the lender is offering you the service of using it’s money. This is quite a valuable service and therefore is not free. In exchange, the borrower pays the lender for this service by paying back the money that was borrowed as well as interest. There are a few different types of interest and certain types are common to certain loans. For simplicity, let’s discuss what is most common; simple interest and compound interest.
Simple interest is the product of the principal, or the amount of money borrowed, the interest rate, and the number of periods in the loan. Most cars loans, for example, use simple interest. Generally, this type of interest is paid over a certain period and is a fixed percentage of the principal amount that was borrowed. As an illustration, if Debbie finances an $18,000 vehicle with an annual interest rate of six percent over three years her interest can be calculated as $18,000*.06*3 or $3,240. Therefore, her total repayment amount would be $21,240 or $18,000+$3,240. Simple interest could reasonably be considered a more “borrower friendly” type of interest because it does not compound on interest. In the long run, this generally saves the borrower money.
Compound interest is the product of the full amount of money borrowed, or principal amount, and one plus the annual interest rate raised to the number of compound periods minus one. For all of those who are not mathematicians on your day job, not to worry! Here’s a much simpler example, suppose Kevin secures a compound interest loan to purchase his new vehicle which costs $20,000 with an annual interest rate of eight percent. Contrary to Debbie’s simple interest loan, Kevin’s compound interest accrues in two ways. First, Kevin will pay interest on the principal balance, the $20,000 he actually borrowed. In addition to that, he will also pay interest on the accumulated interest. With a four year repayment plan Kevin will pay $7,209.77 in compound interest alone, bringing his grand total to $20,000+$7,209.77=$27,209.77. Because he is paying interest on interest, Kevin is paying much more in the end than he would have with a simple interest loan.
As you can see from both illustrations above, the interest rate is not the only factor that determines the amount of interest you will ultimately have to pay. Clearly the loan term length plays a key role as well, no matter what the interest rate. In general, the longer the term the more cumulative interest you will pay. While a longer term loan may reduce the dollar amount of your monthly payments and keep your finances manageable, be sure to carefully consider the long-term truth. The less you pay now, the more you pay altogether.