Hey everyone, thanks for joining me for this week’s Monday Money! Today, I’m going to go over something that most people have some experience with and know very little about at the same time, compound interest rates.
If you have a loan that you were charged interest on, you’ve had experience with compound interest rates. Also, if you’ve had a savings account and you’ve experienced earning money through the combination of money and time, you’ve had experience with compound interest rates. Understanding the inner workings of compound interest rates will help you to gauge the opportunity cost associated with making the decision to put money into savings or pay off debt.
Now, when thinking about compound interest rates relating to savings and debt, it’s important to remember that there is one key difference in the concepts of both. When you think about debt, you want to reduce the overall interest that you pay and when you think about savings, you want to increase the overall amount of interest that you earn. Here are a few tidbits of information that should help you with both!
Avoiding Compound Interest And Debts
When it comes to debts, you are being charged the interest. So the key is, avoiding the amount of interest that you are charged over the life of the debt. That being said, some debts will have a daily compound interest rate and some debts will have a monthly compound interest rate. Here is a brief description of the two…
- Daily Compound Interest Rates – If you are being charged a daily compound interest rate, this means that your interest is being added to your balance on a daily basis. So, if you have a balance of $100 today, your balance will increase by the amount of daily interest at the end of the day. Tomorrow, you will be charged interest on your overall balance including the interest that you were charged today meaning, you are paying interest on interest. Although, this shows poor lending habits, consumers often find terms like these on bad credit loans and some credit cards.
- Monthly Compound Interest Rates – Although, monthly compound interest rates are often calculated on a daily balance average, they will only be charged to your account on a monthly basis. At the end of the month, lenders of monthly compound interest debts will calculate the interest charge for the entire month based on the average daily balance on the account.
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How To Pay Less Interest
When paying down loans, it is best to make more than minimum payments. By paying more than minimum payments, you will quickly reduce your daily balance or average daily balance leading to a smaller finance charge at the end of it all. If you can’t afford to pay more than minimum payments, don’t worry, you can still avoid interest.
No matter if you are paying more than your minimum payment or your exact minimum payment, you should split our payments up by the amount of paychecks you get in a month. If you are paid twice a month, divide your payments by 2 and send in bimonthly amounts. Doing so will cause the average daily balance to reduce in the center of the month leading to less interest than if you waited until you got the bill to make a payment.
Compound Interest Rates And Savings Accounts
When you want to save money, you want to make sure that your money earns as much for you as possible. When it comes to savings accounts, the money earned is thanks to compound interest rates. The same types of rates that cost you money on debts make you money in savings! The best part is, they work about the same so, you already know how they earn you money. One important thing to remember is that most savings accounts have monthly compound interest rates calculated based on your daily balance.
How To Earn More In Savings
As with debts, when you pay more into what you are trying to accomplish, it happens faster. However, because the compound interest rates work the same in both cases, you can also use the multiple monthly payments concept to earn more money in savings. By putting new money into savings at multiple points throughout the month, you slowly increase your average daily balance which is used to calculate your interest payment.
Understanding compound interested is extremely important. By knowing its power will help people understand why it is so important to start saving early.
Sean,
Thanks for your comment, I couldn’t agree more. I recently discovered how much 5 years of lost investment time really costs and…ouch! It’s in the hundreds of thousands for the average Joe over a lifetime.
Compound interest rates will kill you and your finances look over those percentages very carefully before signing anything. Also that’s great advice to split your payments up by the amount of paychecks you get in a month, i had not heard of that one before.
Hey Virginia,
Thanks for your comment, I’m glad you enjoyed this week’s post!
I’m all in favor of paying as much as possible (i.e. more than minimum, if possible) as soon as possible, since then you can start to benefit from compounding of savings, etc.
Mike,
Thanks for your comment, I’m glad you enjoyed my work!
Great points Josh 🙂 The difference between daily and monthly compounding isn’t a lot in the short run, but can make for quite the difference over time. Everyone should familiarize themselves with how interest rates are calculated 😀
Quote: “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
~ Albert Einstein
Hey Liquid,
Thanks for your comment and…I LOVE THAT QUOTE!!!
Thanks for the explanation Josh. It’s true that many people don’t know the difference or anything about it at all. All they see is the bill or the bank account each month and either pay for it or say hey, there’s more money in the account, great but don’t understand why. Cheers
Thanks for your comment CBB! I’m glad you enjoyed the article!
Making more than one monthly payment is a great idea and good way to knock down debts faster. It is frustrating when the lender doesn’t know what to do with extra payments. I’ve had issues with my mortgage and student loans in the past. They sometimes apply it to interest and don’t apply it to the balance. Maybe if everyone did it, companies would be better.
Hey Kim,
Thanks for your comments…I’ve had similar issues in the past. Maybe I’ll write a post about how to avoid them for others!
Well, it’s a wise move and I have my financial planner helping me out to carry out the same. Compounding or generating earnings on an asset’s reinvested earnings is honestly the best way to enhance investments. The more time you give to your investments, the more you are able to accelerate the income potential of your original investment, which takes the pressure off you.
I’m completely with you on that. You don’t even get to know when your humble loan amount blows up to be an enormous amount. Recently, a friend had spiraling debt. He went through a lot of debt consultation, but finally it’s the gold that helped him out in his rainy day. He’s a numismatist and his hobby of collecting these gold coins have been a true savior and got him out of debt and live a debt free life.