If you have any outstanding loans or credit cards, you should be aware that most of these types of credit compound interest. This means that, if you fail to pay off the accrued interest each month, the interest rate you actually pay is higher than that quoted by the lender. Knowing how compound interest affects your bills is crucial for good financial planning.
Compound Interest
Compound interest is the interest of accrued interest. This differs from simple interest, which is usually the rate quoted by lenders. You can convert simple interest to compound interest fairly easily with the use of a calculator. Let's say that interest is accrued monthly on your loan or credit card. Divide the simple interest, often quoted as APR, by 100 to convert the number to a decimal form. Then, divide by 12, as there are 12 months to a year. Add one, and raise the number to the power of 12. Subtract one, and multiply by 100. This gives you the compound rate of interest, which will be higher than the simple rate.
Minimum Payments
Most types of credit, including credit cards calculate interest on a daily rate, not a monthly rate, and then charge the total amount at the end of the month. The minimum monthly payment on credit cards may often be lower than the simple monthly interest rate. If you have such a card, and make only the minimum payment, compound interest will occur as the accrued interest is added to the principal. Thus, even if you haven't made any further purchases, your next bill will be higher.
Avoiding Compound Interest
There is a way of avoiding compound interest. Using the example of credit cards, if you make more than the minimum payment, your bills will gradually fall over time. Specifically, you should ensure that you pay off all of a given month's accrued interest as well as some of the principal. Your monthly credit card bill, by law, must state the monthly accrued interest and principal. You then know how much to pay each month in order to reduce your bills.
Student Loans
Federally backed student loans and some private student loans do not use compound interest when calculating the total amount owed. Student loan accounts are often divided into two parts: the outstanding principal and the accrued interest. Further amounts of interest is only charged on the principal, not the interest. As a result, you may use the simple interest rate when calculating the amount you owe on student debt. So, in any given month, your bill will increase only by the annual rate divided by 12.
0 comments:
Post a Comment