PF1 - Interest Rates Lesson
Interest Rates
Comparison of Interest Rates on Loans and Credit Cards from Different Institutions
| Type of Credit | Interest Rates |
|---|---|
| Personal loan (from bank) | Usually offers a lower interest rate than a credit card |
| Credit Card |
Interest typically higher than personal loans Interest and fees can add up |
| Payday Loan |
Extremely high interest rates Considered predatory loans due to their extremely high interest and fees |
APR v. Interest Rates
Annual percentage rate (APR) is the annual cost of a loan to a borrower — including fees. Interest rate refers to the annual cost of a loan to a borrower. Both APR and interest rates are expressed as a percentage. The higher your interest rate, the higher your monthly payment on a loan.
Types of Interest
When you deposit money in a savings account, the bank pays you interest. Fixed interest does not change over the life of a loan or investment, while variable interest goes up and down with inflation. When you borrow money for college, a car, a house, or another major purchase, you pay interest. As a saver, you would like to earn compound interest. As a borrower, you would like to pay simple interest. Let's find out why.
Simple Interest
The equation below delineates how you find interest.
I = P x R x T
Interest = Principal x Rate x Term
Example 1: Given the following parameters, calculate the amount of interest paid and the total amount at the end of 5 years.
Principal = $5000
Rate = 5%
Term = 5 years
What is the Interest? $6250
Compound Interest
I = P x (1+r)t -P
Interest = Principal x (1+ rate) term - Principal
Example 2: Given the following parameters, calculate the amount of interest paid and the total amount at the end of 5 years.
Principal = $5000
Rate = 5%
Term = 5 years
What is the Interest? $6381.41
Amortization
Unlike credit cards, where you ultimately decide how much of the monthly balance to pay off each month, most loans are amortized. Amortization is the reduction of a loan balance through payments made over a period of time.
Check out the amortization schedule below.
When loan payments are amortized, the total amount you owe every month is the same.
Why does the amount of interest you pay decrease every month? The amount of interest you owe decreases every month because the outstanding balance (principal) is less.
What happens to the principal paid over time? With each consecutive bill you pay, you are paying a slightly smaller bit toward interest and a slightly larger portion toward principal. So, the amount and proportion of principal you pay every month goes up. If you make EXTRA principal payments, your loan will be paid off sooner.
Inflation and Its Effects on Your Savings and Investments
Inflation is the rate at which prices for goods and services are increasing, so the relative purchasing power of money decreases over time. With inflation, it would take more money in the future to buy the same basket of goods than it would today. Since money is worth less over time (because of inflation), it is important that money in a savings account increases or grows over time. Savers should seek out investments - whether in a savings account or other investment options - where the rate of return is at least as high as the rate of inflation. If the rate of return is less than inflation, than the money in the savings account is losing purchasing power over time and will not be worth the same amount, in goods and services, in the future as it is today. Nominal returns are the actual returns earned by the investor, while the real rate is what you earn on an investment after accounting for taxes and inflation. Real returns are lower than nominal returns, which do not subtract taxes and inflation so pay attention to the real returns!
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