Do You Understand Interest Rates? Neither Did I.

09/19/16Colin Grubb

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To those of you who are financially savvy this article is going to elicit a big sarcastic “duh!” I advise you to skip it and go back to your monthly budgeting, retirement planning, fully paying off your credit cards every month, or any of the other responsible things you seem to automatically understand.

I’m writing this, and all subsequent finance related pieces, for people like me. People who get a migraine and need to sit down at the mere mention of phrases like IRA, home equity loan, or investment portfolio.

We’ll call this series “Things it Would Have Been Incredibly Useful to Learn in School,” or if you actually had an Economics course: “Things They Taught Us in School While We Weren’t Paying Attention and Therefore It’s Our Fault Man, We Can’t Blame the System.”

Interest Rates

I’ve never understood them. (Hopefully all the smart people have gone now as this is going to be really basic.)

I have a mortgage, I have a car loan, I also have student loans, and I really don’t have much of an idea how the interest works or the monthly payment is determined. I just pay the bills each month and don’t ask questions.

Recently, at tax time, I needed to take a deeper look at my wife’s student loan and I noticed that, although I had been paying it off for two years, the loan amount had not come down anywhere near the amount I had paid.

My friend said this was because when you get a loan, you are initially paying back mainly the interest rather than the amount you borrowed.

I thought if you got a loan for $30,000 at 5% over 10 years they added the 5% ($1,500) to the $30,000 giving you $31,500 which they then chopped up equally into 120 monthly payments and that’s it right?

No, nitwit.

The interest rate is compounded monthly.

Migraine.

Here’s how it works, class. This is an incredibly basic fixed-rate loan scenario. We’ll move on to more complicated, real world scenarios once we’ve got this under our belts.

Take the above loan: $30,000 at 5%. The key to understanding this is we’re going to be looking at monthly snapshots. The 5% refers to the Annual Percentage Rate, that’s the whole year. We need to find what that is monthly. Every month we’ll apply this monthly percentage to the principal (amount owed) and recalculate.

To do this we need to first convert 5% to decimal = .05. Then divide .05 by 12 to get the monthly rate: roughly .0042.

Ok, so your first payment we apply .0042 to the full amount $30,000. This gives us $126. Your interest on the first payment is $126.

Here’s the next crucial thing to understand. The monthly interest on the loan must be FULLY PAID OFF every month.  So for month 1, if your monthly payment is $318.20, $126 of that goes to pay off the interest in full leaving the difference, $192.20 to apply to the $30,000.

This means out of your $318.20 payment, you’ve only really spent $192.20 to pay off the loan.

See?

So when we get to month 2, the amount you owe on the loan is now $29,807.80. Now you apply the .0042 monthly rate to the new total you get $125.19. So once again you must pay off all the interest leaving $193.01 to go toward the loan.

And so on, and so on.

Over time, as you chip away at the loan, the amount of your monthly payment that goes toward interest gets less and less and the amount that goes toward the actual loan balance gets more and more.

So it’s not as simple as just paying 5% of $30,000. Since the interest is recalculated on a monthly basis, when all is said and done you’ll have paid roughly $8183 in interest on this loan by the time it’s finished.

You might be saying now: “I understand how they get the interest payment, but how do they figure out what the whole monthly payment ($318.20) is in the first place?”

That’s a little more complicated and we’ll leave that until the next article. In the meantime put your new knowledge to use and check out some of our featured lenders.

Do you own a house? Are you interested in refinancing your mortgage? Have a look at our featured top ten mortgage refi companies.

Are you drowning in credit card debt? Check out our list of the best personal loan providers. Maybe you can qualify for a personal loan to consolidate your monthly payments.

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