What You Should Know About Interest Rates

Summary: For all people shop around for the best rate, there are few who have taken the time to sit down and add it all up. After all, why would you bother? The answer is that understanding just how interest rates work can help you see how important small differences in rates and payment amounts can be.

For all people shop around for the best rate, there are few who have taken the time to sit down and add it all up. After all, why would you bother? The answer is that understanding just how interest rates work can help you see how important small differences in rates and payment amounts can be. Interest Rates are Compound. It is important to remember that what you owe is compounded - that means you pay interest on the interest you owe from the month before. That means that if you're paying 2% per month in interest, you're not paying 24% per year - you're actually paying 26.82%. Charging interest monthly instead of yearly is a trick to make it feel like you are paying a very low price for your borrowing. A Thought Experiment. Here's a question: would you rather have $1 million, or $10,000 in a savings account earning 20% per year in compound interest? Well, let's see how that $10,000 would grow. After 10 years: $61,917. 20 years: $383,375. 30 years: $2,373,763. 40 years: $91,004,381. 50 years: $563,475,143. So after fifty years, you'd have over $500 million?! Well, not so fast. Of course, you have to take inflation into account - if we say inflation is 5%, then that money would have the buying power that $10,732,859 does today. Still, that's not a bad return on your investment of $10,000, is it? That's the power of compound interest, and the way the credit card companies make their money (it's also the way pensions work, and the reason the prices of things seem to rise massively as you get older). Be very, very afraid of compound interest. Or, of course, you could start saving, and be very glad of it