Do you avoid gambling on the stock market or at a casino because you fear heavy financial losses? You may be surprised to hear that you're just as likely to lose money because of your everyday banking decisions. Many people collect only 1 to 3% interest on money in a savings account while simultaneously paying rates as high as 18 to 20% on credit card balances. Over time, this can mean some pretty heavy losses.
With some math smarts and an understanding of simple and compound interest, you can manage the way your money grows (and ideally keep it from shrinking). The principles of simple and compound interest are the same whether you're calculating your earnings from a savings account or the fees you've accumulated on a credit card. Paying a little attention to these principles could mean big payoffs over time.
Understanding the basics
When you put money in a savings account, the bank pays you interest according to what you deposit. In effect, the bank is paying you for the privilege of "borrowing" your money. The same is true for the interest you pay on a loan you take from the bank or the money you "borrow" from a credit card.
Interest is expressed as a rate, such as 3% or 18%. The dollar amount of the interest you earn on a savings account is figured by multiplying the money you deposit (called the principal) by the rate of interest. If you have $100 in an account that pays only 1% interest, you'll only earn $1 in interest. If you shop around for an account that pays 5% interest, you'll earn five times that amount.
In banking, interest is calculated and added at the end of a certain time period. You might have a savings account that offers a 3% interest rate annually. At the end of each year, the bank multiplies the principal (the amount in the account) by the interest rate of 3% to compute what you have earned in interest.
Interest on interest: Compounding
There are two basic kinds of interest: simple and compound. Simple interest is figured once. If you loaned $300 to a friend for one month and charged her 1% interest ($3) at the end of the month, you'd be dealing with simple interest. Compound interest is a little different. With compound interest, the money you earn in interest becomes part of the principal, and also starts to earn interest. If you loaned that same friend $300 for one month but charged her 1% each day until the end of the month, you'd be using compound interest. At the end of the first day, she would owe you $303. At the end of the second day, she would owe you $306.03. At the end of the third day, she would owe you $309.09, and so on.
Compound interest is what makes credit cards and loans so difficult to pay off. The rules of interest are the same ones that increase your savings over time, only with credit and debt, they're in the bank's favor—not in yours. With some rates as high as 21%, collecting interest on credit card loans can be a lucrative business.
