July is savings month. One of the economic principles that make it worth your while to save money, is the fact that you can earn interest. Here then is an introduction to everything that makes interest interesting.
When you borrow money, you always pay back more than what you borrowed (unless the lender is your dad or a generous friend). This difference is largely due to interest. In simple terms, interest is the cost of using somebody else’s money. When you borrow money, you pay interest. When you save money, you earn interest.
When you borrow, interest works against you
The reason for paying interest when you borrow money is to compensate the lender for the risk of lending to you, and for the fact that the lender cannot use the money anywhere else while you have it. The latter is called opportunity cost.
The more you borrow and the longer you take to repay the loan, the higher the amount of interest you pay. That is why you should never borrow more than what you actually need, and why you should keep your loan period as short as possible.
When you save, interest works for you
When you put money in a savings or investment account, the bank uses your money to offer loans to other customers and make other investments. Periodically, (every month or quarter, for example) the bank pays you interest on your savings.
Interest is the sweetener to encourage you to save, instead of spending all your money today. You can either spend that money or keep it in the account so it continues to earn interest.
Your savings can really build momentum when you leave the interest in your account.
How is interest calculated?
There are two types of interest:
- Simple interest is calculated only on the principal amount of a loan.
- Compound interest is calculated on the principal amount and the accumulated interest. In other words, you pay interest on interest, which could see your debt skyrocketing in a short time. Conversely, your savings will really take off once you start earning interest on top of the interest you have already earned.
For both types, the interest rate determines how much you pay or earn. A higher rate means the borrower pays more and the lender (and saver) gets more.
Let’s see how simple and compound interest work in real life.
Say you deposit R1 000 in a savings account that pays a 7% per year interest rate. With simple interest, you will earn R70 over one year, bringing your account balance to R1 070. At the end of the following year, your balance will be R1 140.
With compound interest, you will still earn R70 in the first year. In the second year, however, your interest will be calculated on R1 070, instead of R1 000. As a result, you will earn R74,90 in interest, bringing your balance to R1 144,90. In the third year, interest calculated on R1 144,90 will earn you R80,14.
Can you see how the interest amount grows every year, despite the interest rate staying the same? That’s the magic of compounding.
How to be interest savvy
- Whether you want to borrow or save, it is worth the effort to shop around for the best interest rate. Even 0,5% can make a big difference over time.
- Make sure you understand how the interest will be calculated before you sign a loan agreement or open a savings account. With compound interest, you can end up paying or earning far more than you thought you would.
- When you save, don’t withdraw your interest earnings; by leaving it in the savings or investment account, your money is working harder for you.
- When repaying a loan, make sure you always cover at least the agreed instalment. By doing so, you will avoid arrears interest being added to your outstanding balance.
- Whenever possible, pay more than your loan instalment. By reducing the capital amount, you are also reducing the interest you pay over time.