Things you might not have learned in school but should know about: Types of interest and how it works - interest we pay

You may have heard the term "interest" used in the context of credit cards, loans, and investments. There are a few different kinds of interest to know about. Some are good and can be used to your advantage, while some are less desirable, and can end up costing you a lot of money.The first category we'll discuss is the cost of borrowing money. This typically comes from a loan for a large purchase, or from using a credit card. When you take out a loan or use a credit card, you're borrowing someone else's money (the lender's or credit card issuer's), and they charge you a fee for that privilege. This fee is called interest.

How Interest Works on Loans

Loans are typically structured as installment loans, meaning you receive a lump sum of money upfront and then pay it back in fixed, regular (usually monthly) payments over a set period of time (the "term" of the loan).

• Principal: This is the original amount of money you borrowed.
• Interest Rate: This is the percentage charged on the principal. For most traditional loans (like personal loans, auto loans, or mortgages), this is often a fixed interest rate, meaning it stays the same throughout the loan term. Some loans, however, can have variable interest rates that fluctuate based on market conditions.
• Annual Percentage Rate (APR): For loans, the APR is a more comprehensive measure of the total cost of borrowing. It includes not just the interest rate but also any additional fees associated with the loan, such as origination fees. This is why the APR is generally higher than the stated interest rate for a loan. It's the best number to use when comparing different loan offers.
• Amortization: Loan payments are typically amortized. This means that early in the loan term, a larger portion of your monthly payment goes towards paying off the interest, and a smaller portion goes towards reducing the principal. As time goes on and the principal balance decreases, a larger portion of your payment goes towards the principal and less towards interest.
• Simple vs. Compound Interest: While some loans might use simple interest (calculated only on the original principal), many larger loans, like mortgages, use compound interest, though it's often structured differently than on credit cards. On an installment loan with compound interest, the interest is typically calculated on the remaining principal balance, and it still leads to more interest paid over time if the principal isn't reduced efficiently.

Example of a Loan: You take out a $10,000 personal loan at 8% APR for 3 years. Your monthly payment would be a fixed amount. A portion of that payment goes to interest, and a portion goes to principal. Over the 3 years, you'll pay back the original $10,000 plus the accumulated interest. While you borrowed $10,000, over three years you will pay approximately $313.36 per month, or $11,281.09 total.

How Interest Works on Credit Cards

Credit cards operate on a revolving credit system. You have a credit limit, and you can borrow up to that limit, repay what you've borrowed, and then borrow again. This cycle can continue indefinitely as long as you make your payments.

• Annual Percentage Rate (APR): For credit cards, the term "APR" is generally used interchangeably with "interest rate." It's the annual rate at which interest is charged on your outstanding balance. Credit card APRs are typically much higher than personal loan APRs.
• Grace Period: Most credit cards offer a "grace period" on new purchases. This is a period (usually 21-25 days) from the end of your billing cycle to your payment due date. If you pay your entire statement balance in full by the due date, you typically won't be charged any interest on those new purchases. This is a key difference from most loans, where interest starts accruing immediately.
• No Grace Period for Certain Transactions: Be aware that grace periods often don't apply to cash advances or balance transfers. Interest on these transactions usually starts accruing immediately from the date of the transaction.
• Compounding Interest (Daily): This is where credit cards can become very expensive. Credit card interest is almost always compounded daily. This means that each day, interest is calculated on your current balance (which includes the original purchases and any interest that has already accrued). This "interest on interest" effect can cause your balance to grow rapidly if you only make minimum payments.
• Average Daily Balance: Credit card companies typically calculate interest based on your average daily balance during the billing cycle. They take your daily balance, add it up for all days in the cycle, and then divide by the number of days to get the average. Then, they apply the daily interest rate (APR divided by 365 or 360) to this average daily balance.
• Minimum Payments: Credit card statements will show a minimum payment due. This is usually a small percentage of your outstanding balance plus any accrued interest and fees. While making the minimum payment keeps your account in good standing, it will significantly prolong the repayment period and result in paying a large amount in interest due to daily compounding.

Example of credit card payment: You have a credit card with a 20% APR. 

* Scenario 1 (Pay in full): You charge $500 in a month. If you pay the full $500 by the due date, you pay $0 in interest. 

* Scenario 2 (Carry a balance): You charge $500 but only pay the minimum payment of $25. The remaining $475 will start accruing interest daily at 20% APR. The next month, interest will be calculated on the $475 plus the interest that accrued in the previous month, plus any new purchases you make.

Understanding these mechanics is vital for responsible financial management. For credit cards, paying your balance in full each month is the best way to avoid interest charges. For loans, understanding your APR and the amortization schedule helps you know the true cost of your borrowing.