As college students leaving home for the first time and becoming more financially independent from our parents, it is important that we familiarize ourselves with basic concepts when learning to deal with money. One of the most important concepts to understand is interest rates, and how they can affect our financial lives in good and bad ways. An interest rate is a percentage at which interest is paid by borrowers for the use of money that they borrow from lenders; in other words the cost to borrow money. Interest rates are commonly seen in credit cards, student loans, and mortgages. However, interest rates can also benefit you as a saver when banking institutions pay you for the use of your money, especially when you start saving at a young age.
A Simple Interest Rate is a percentage of an amount, called the Principal, which can be on an annual basis. Here’s a quick example of how simple interest works. If you were to put $1,000 into a bank account, and were given a simple interest rate of 5%, the amount of interest you would earn at the end of the year is:
Principal amount * Simple Interest Rate = Amount earned
1000* .05 = $50
You would earn a nice return of $50 dollars for allowing the bank to borrow your money for that year. As we can see, simple interest is very easy to calculate which is why it is called a simple interest rate. You would continue to earn $50 dollars each year if you decided to keep the $1,000 in the account. Over 30 years you would earn $1,500, and over 50 years you would earn $2,500.
The same would apply if you were borrowing $1,000 and paying a simple interest rate annually. It would cost you $50 per year to borrow that $1,000.
Compound Interest works a little a bit differently. You don’t see a lot of results in the short-term, but in the long term compounding can make a big difference. Compound interest is calculated on the initial principal amount and the amount of interest built up. Because of this interest build up, compound interest will grow at a faster rate than simple interest. In other words, you are earning interest on both the principal and the interest earned, rather than just the principal as in simple interest.
For example, if you put $1,000 into an account when you are 20 years old and the rate that is paid is 5% per year compounding and you just leave it alone, never adding or taking anything out, after 30 years you will have $4,321.94; after 50 years you would have $11,467.40. As you can see, with compounding you earn more than with simple interest – an increase of $2,821.94 for 30 years and $8,967.40 for 50 years.
Calculating compound interest is a bit more complicated. You can calculate compound interest on a financial calculator, but there are several calculators available on the internet. Just search “compound interest calculator”. One of my favorites is http://investor.gov/tools/calculators/compound-interest-calculator
Compounding can be a great tool to save money easily. You can really see the benefits of compounding if you start saving early as possible, make regular contributions to the account, and leave the money alone to grow over time. Even though interest rates paid on savings are very low right now, at some point in the future the rates should rise and understanding the concept of compounding can help you become a more disciplined saver.
Unfortunately, compounding can also work against you especially when you are borrowing money. Most students run into this through the use of credit cards. An interest rate you may have heard about before in regards to credit cards is the Annual Percentage Rate (APR). This rate is the annual rate that is charged for borrowing, stated as a percentage that represents the actual yearly cost of not paying off your credit balance on or before the due date. Students can use credit cards to establish credit history, it is more convenient than writing checks everywhere and you have a record of all purchases. However, credit cards are among the most expensive types of debt, with some of the highest interest rates and fees.
The APR on credit cards can be hard to track. There are different rates charged for various transactions or time frames. For example, most cards try to give you a low, introductory rate, then after a few months, it goes up. Also, students without a long credit history will likely be charged a higher rate. Cash transactions usually are charged a higher APR than regular purchases. If you miss a payment, you could be charged a penalty APR.
Most credit card companies use a Daily Periodic Rate (DPR) and Average Daily Balance to calculate interest charges. The DPR is calculated by taking the APR and dividing it by 365 (number of days in the year). The Average Daily Balance is figured by adding up each month’s daily balance and dividing it by the number of days in the month. The amount of interest you will pay is calculated using this formula:
Card Balance X DPR X days in statement billing cycle
Because of all the variables involved in differing rates and fees, it is very important to check your credit card’s particular rates and fees schedule on the statement to see how they are calculating transactions and what other fees they charge. The best advice is to pay off your credit card balance every month before or by the due date!
Understanding interest rates and how you can make them work for you is a great first step in building a strong financial future. If you have any questions on how interest rates work or any other financial questions, schedule an appointment with Powercat Financial Counseling by going to our website www.ksu.edu/pfc!
Brett Zapletal
Peer Counselor I
Powercat Financial Counseling
www.k-state.edu/pfc
