Understanding Interest and How It Works

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Understanding interest can help you make smarter decisions about your finances in the long-run. By taking the time to learn how it works, you can be better equipped to stay in control of your money and avoid surprises. 

Let’s look at some basic interest concepts and what they mean for you. 

What is interest?

Interest is the cost of borrowing money or the reward for saving it. It is typically calculated on an annual basis (per annum), though it can also be applied monthly or daily depending on the terms of the loan or savings account.

When you borrow money, banks and lenders can charge interest as a fee for lending you money. In some cases,  interest charges may accrue and grow over time, the longer it takes you to pay back your loan. This may sometimes be referred to as interest paid. Some examples when this type of interest can apply are credit cards, home loans and personal loans.

On the flip side, when it comes to saving your money, some banks can also allow you to earn interest as an incentive for saving your money using one of their specific savings accounts. This may sometimes be referred to as interest earned. Some examples when this type of interest can apply are term deposits and savings accounts.

Simple interest v compound interest

• Simple interest: This interest is calculated only on the original amount of money deposited (the principal) and the interest won’t change over time.
• • Example -  Let’s say you borrow $5,000 at a 5% simple interest rate over 3 years. By the end of those 3 years, you would have paid $750 in interest charges on top of the original loan amount.
• Compound interest: Compound interest allows your money or debt to grow faster over time because your interest is charged or grown based on the total (inlcluding previous interesd). When borrowing, compound interest increases the amount you owe, meaning a lower interest rate is better.
  • Example - Let’s say you borrow $5,000 with a 5% p.a. compound interest rate over 5 years. By the end of those 5 years, you would have paid $788.13 in interest charges, which is slightly higher than if you had a simple interest plan. In this example, it may not seem much but for larger loans it can really add up.

Compound interest generally generates more growth over time compared to simple interest. This is because compound interest generates interes based on the new  However, keep in mind that this is also applicable to loans where compound interest means that the longer your payment terms, the more interest you will have to pay.

Fixed interest rate vs variable interest rate

When managing your money and applying for loans, you might also have come across terms fixed and variable interest rates. Here’s a quick look at how the two differ: of both types of interest rates

• Fixed interest rate: This type of rate stays the same for the life of your loan or savings account. It makes it easier to budget because your repayments or interest earnings are predictable. 
• Variable interest rate: Variable rates can change, usually based on the market. While they can start off lower than fixed rates, they might go up over time, which could increase your repayments. 

You might see these types of interest rates associated with home loans, car loans, credit cards and personal loans.

How does understanding interest help with managing my finances?

Understanding how each type of interest rate works can help  you choose the option that best suits your situation. This can help you manage your repayments more effectively and avoid unexpected costs down the line. Here are some other reasons why:

• Make informed decisions: Knowing how interest works can help you choose loans or savings accounts that best suit you and your situation, helping to avoid surprises like high repayments or low returns.
• Control debt: Interest can quickly add up, which can cause extra strain on your finances in the long-term. This can be the case with high-interest loans or credit cards when you only make the minimum repayments or don’t pay off your credit card in full by the due date. Understanding how interest works and can help you stay on top of your debt and avoid getting trapped in a revolving debt cycle. 
• Maximise savings: Knowing how interest works with specific savings accounts offered by some banks can help you develop some savings strategies and grow your savings faster. 
• Prepare for rate changes: If you have a variable-rate loan, interest rate changes can affect your repayments. Keeping an eye on market trends, you can anticipate these changes and adjust your payment strategy accordingly. For example, when the rate drops, you could make extra payments to reduce the principal and save on future interest costs. 
• Spot hidden costs: Understanding interest can help you avoid hidden fees or tricky loan terms that can cost more in the long run. Some loans can come with prepayment penalties, meaning if you pay off the loan early to avoid further interest, you might receive extra fees. One example of a hidden cost is a promotion or “teaser rate” that might offer a low or even 0% introductory interest rate for a period of time. If you aren't aware of the full loan terms, such as the date at which the rate will change or how much it will change to, you could end up paying much more interest than expected.

For a real-life example of how interest rates can impact you, we can consider how interest rates changed during COVID. During COVID, interest rates hit an all-time low, and over 46% of Australians locked in fixed rates to take advantage of the low rates. Now, while rates are rising post-pandemic, those with fixed rates are staying protected from rising payments, while others are feeling the pinch from the increases.

Tips for managing interest effectively

Managing interest effectively can save you money and help you stay in control of your finances. Here are some tips to help you stay ahead:

• Assess your financial situation: Review your finances to ensure you can comfortably afford the repayments. Make sure you are aware of your financial capabilities.
• Stay updated on changing interest rates: Keeping an eye on interest rate changes, especially if you have a variable-rate loan could save you money if rates drop. On the other side, if interest rises you could plan to refinance to a fixed-rate, make extra payments before interest rates hike again or even as simple as do some extra budgeting.  Being proactive allows you to make adjustments when necessary and making sure you get the best deal possible.
• Use an interest calculator: This can be a great tool to quickly see how much interest you’ll pay over the life of a loan. It can help you assess whether you can afford the loan and compare different loan options, giving you a clearer picture of your financial commitment. Here is an example of a compound interest calculator.

By knowing how interest works, you can be better equipped to predict changes, spot better deals, and make informed decisions about your savings and loans. Also if it’s your first time applying for a personal loan, you can find great tips to help make informed decisions on our blog here.

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