You may be more than a quarter of a century away from retirement and thinking more about getting yourself rather than your kids through college. However, time has a way of flying by. What you do now impacts what you can do later. Interest is money earned for the use of your money -- think savings account. Or money you have to pay for the use of someone else's money -- think credit card. How the interest is calculated has an impact on your future and your present.
You don't have to be a rocket scientist to figure this one out. Simple interest is a percentage you multiply by the amount of money for the agreed-to time period. For example, you have a savings account that has a balance of $1,000 and earns 4 percent annually. You will earn $40 on that account for the first year. If you leave the money in the account after the interest is paid, the calculation begins with a new principal amount for the next time period. In this example, the second year will start with a balance forward of $1,040.
The interest is being earned every day the money is in the account. However, if it isn't paid out until the end of the year, quarter, or whatever the contracted period of time is, the interest is said to be accrued. It's owed to you but not paid. The institution where you have the money invested would show the accrued interest as a liability on its balance sheet while you would show it as an asset. It is money owed to you.
If you're on the receiving end of the money, you want the highest interest rate possible. Not only that, but you also want the interest to compound. Compounded interest means you earn interest on the interest. A daily compounded interest rate will earn you more money than a monthly compounded interest rate. The interest could accrue or be deposited into our account as earned. That's the good news.
The bad news is that most credit card companies use compounded interest to calculate what you owe them. And they calculate the interest from the day the charge was made, if there is no grace period. A $10,000 watch bought with a loan at 28 percent simple interest would cost $12,800 at the end of the year. It would cost $13,230 at 28 percent interest compounded daily.
And the Ugly
If you only pay the minimum monthly payment it will take years to pay off the card. That $10,000 watch payoff will require 12 years and five months and cost you a total of $8,297.00 in interest. You could have bought a Rolex.
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