Understanding Interest Rates

Most people have probably heard about interest rates in some form or another. However, understanding what interest rates are, why they are used, and how they can work for or against you can be the difference between using interest to your advantage and falling victim to it.

Broadly speaking, interest is a gradual accumulation of cost based on the amount of money in question and a certain amount of time. Sound confusing? Let’s break it down with a few examples. For these examples, we’ll be using the following equation:

Example 1: You borrow $5,000 to buy a car at 10% interest per year. In this scenario, each year that you don’t pay back that loan you would owe 10% more or $500 more. So in one year, that $5,000 would grow to $5,500. In two years, $6,000, and so on.

Example 2: You deposit $5,000 in a bank that offers you 1% interest per year. In this scenario, your bank is worth $50 each year that it’s in the bank. So in one year, your money grows to $5,050. In two years, $5,100, and so on.

In these examples, we can see how interest can work for someone or against someone, depending on the use case. You’ll also notice a key difference: usually, you pay far more in interest than you would ever earn in interest. This is because the entity loaning money is taking a significant risk: they are counting on you to pay them back the money they loaned you. To make up for that risk, they charge high interest to incentivise you to pay them back quickly.

Pay close attention to interest rates when borrowing money or making large purchases. Some lending entities may offer you a grace period where you aren’t charged interest, as is often the case with credit cards. Use this grace period to your advantage to pay off the loan before you are charged interest.

Remember: being charged interest is the same as losing money, so try to minimise that as often as possible.

Likewise, be on the lookout for institutions that offer you high interest for the privilege of storing your money for you. Most banks do not offer very high interest at all; often, they offer less than 1% interest on your savings. However, an increasing number of cryptocurrency companies are offering high-interest rates on stablecoins held with them. While the security and longevity of these companies are sometimes in question, a 10% interest rate on stablecoins held at a cryptocurrency company can be quite attractive; as always do your own research to determine what options are right for you.

People who borrow money and do not pay it back are at risk of their debt ballooning very quickly. High interest rates are common when borrowing money; owing 25% interest, 50% interest, even 200% interest is not uncommon in the financial industry. For this reason, it is important to pay off your loans as quickly as possible. 

Sometimes, people have such high interest rates that they can only pay off the increasing interest, not the principal amount. This means that although you are making payments, your actual amount owed never gets any smaller. For this reason, make sure that whatever payments you make are also lowering the principal owed, not just the new interest charges.

Additionally, compounding interest can quickly increase the total amount owed. You can try out a compound interest calculator here to see how an amount owed can grow more rapidly than you would think. Compound interest on a debt owed can be an incredibly stressful financial problem to navigate. However, compound interest on a retirement account, for example, can grow the amount you’ve saved just as fast.

As always, we encourage you to do your own research when making any financial decision. There is a lot of noise that will be encouraging you to make financial commitments with various interest rates; in all of these situations, you should carefully weigh your options, run the numbers yourself, and seek advice from people you trust. When used wisely, interest can be a powerful tool for building your wealth. However, not paying attention to interest rates can just as quickly diminish your money. Stay in control of your financial future by putting interest to work for you, not against you.