How Interest Works Against You or for You
Simple interest is the type of interest used for most consumer loans. The original amount of the loan is your principal. For example, if you bought a washing machine for $1,000 and put no money down, your principal would be $1,000. The interest accrued or accumulated is calculated by counting the number of days since your last principal payment multiplied by your daily interest factor on the outstanding balance. Here’s an example:
Loan balance or principal = $1,000
Interest charge = 13%
Your first payment = $50
Number of days since last principal balance payment = 30
Daily interest factor ($1,000 x 13% /365) = $0.36 (So, you pay 36 cents a day interest.)
Amount of interest owed (30 days x $0.36) = $10.80
Amount of your payment that goes toward the principal ($50–$10.80) = $39.20
New loan balance after payment ($1,000–$39.20) = $960.80
If you continue making payments of about $50 every month, it will take you approximately two years to pay off your loan and during that time you will have spent an additional $141 on interest payments. If, however, you make payments of $90 every month, it will take you half the time to pay off your loan and you will have only spent approximately $72 on interest payments.
The average American with a credit file is responsible for $15,788 in debt, excluding mortgages, according to Experian, a credit reporting bureau.
The longer you take to pay off your loans and the smaller the amounts you pay toward the principal, the more money you pay in interest. An amortization table can show you how long it will take you to pay off your loan and how much interest you will pay during that period.
You can find amortization calculators online, and many banking websites also offer them. You can use these not only to determine how quickly you can pay off your current debt, but also to get a realistic grasp of how much it’s actually going to cost you to borrow.
Interest can work for you, too. If you have a checking or savings account that earns interest, the money you have deposited in it is growing. However, before you start putting money into a savings account earning 4 percent interest, be sure you are not maintaining a balance on a credit card at 16 percent interest. You are actually losing money by not paying off the credit card first. Only after eliminating debt should you put your money into a savings account, with the exception of allowing a small amount to be saved in case of emergencies.