Issue 12  •  Spring 2013

Interest: You Can't Escape It!

Written by Andrea Davila
      Active Image                                                           Interest is a little like bacteria—all around us, growing and dispersing, affecting our lives in ways we don't initially understand. And we're never sure whether it's an enemy or a friend—should we be taking those antibiotics, or letting kids play in the dirt? Are we supposed to be excited or disappointed when "the Fed lowers the interest rate?" What IS interest, and how do interest rates affect us?
Image
Interest is a little like bacteria—all around us, growing and dispersing, affecting our lives in ways we don't initially understand. And we're never sure whether it's an enemy or a friend—should we be taking those antibiotics, or letting kids play in the dirt? Are we supposed to be excited or disappointed when "the Fed lowers the interest rate?" What IS interest, and how do interest rates affect us?

 

The most simplistic definition of interest is this: a fee for the use of borrowed money over time. When you're out to lunch with a friend and you pay for him or her, your buddy might reply "Thanks, next time I'll by you lunch AND a cupcake!" That cupcake, the extra your friend is giving you for the convenience of using your money, is interest. You are getting a little bit more back than you lent out. If you're the borrowing friend, you're paying back a little bit more than you were originally lent. This is the one of the basic tenets of interest to keep in mind: borrowers pay interest, lenders earn it.

You might not realize it, but most of your money is engaged in these borrowing/lending transactions daily. If you're one of the 78 percent of Americans who has at least one credit card, you're agreeing to borrow money from the issuing bank/company by using that card. In return, you have to pay a fee determined by an interest rate, which in credit card terms is usually called the "APR," or annual percentage rate. This number represents the percentage of your credit card balance you have to pay in fees for borrowing money.

Since you're the borrower in this situation, you're ideally looking for a low interest rate so you pay less in fees for borrowing money. While the credit card industry has a terrible reputation for inflating APRs until they are unmanageable for most people, Obama is working to change some of these regulations. It is important to note that credit cards are structured so that you never have to pay a fee for borrowing if the debt is repaid within thirty days. Therefore, if you're a borrower who repays the amount you borrowed within thirty days each time—meaning you never carry a balance—you never have to pay a fee, which is actually a pretty sweet deal if you think about it. Incidentally, the credit card industry calls people like that "deadbeats," perhaps the only instance in life where you'd be happy to be one.

Even without a credit card, you're not exempt from the effects of interest. Most likely you have a checking or savings account with a local bank. Banks work by collecting deposits from account holders and using that money to make loans to borrowers. That's why you can get a mortgage AND a savings account from Bank of America. You are lending the bank your money to use, and in return they usually pay you interest on the balance in your account.

The rate of interest you get paid depends on the type of account. Lending the bank more money over a longer period of time will ensure you a high interest rate. This is why rates for products like CDs (Certificate of Deposit), which ensure the bank your money for a specified period of time, are higher than savings accounts, which are higher than checking accounts, which have low/no minimum balance or withdrawal limits. For a specific breakdown of the interest you are earning on your accounts, contact your bank. Since you're the lender, you're ideally trying to get the highest interest rate possible. If you’d like to find out more about the interest rates you could be earning on different kinds of accounts, check out BankRate.com, a popular aggregator of financial rate information.

Whether the interest rate for your savings account is 3 percent, 5 percent, or 1 percent, all depends on yet another interest rate, the Federal Funds Rate, which is the interest rate you hear about in the news. The Fed Funds Rate is the tool the government uses to regulate the economy. While we've talked above about the borrowing and lending you do in your everyday life, there is also borrowing and lending taking place on a vast scale between banks.

The Federal Reserve Board decides the fee, or interest rate, that banks can charge to lend to one another. And if it is more expensive, i.e. a higher interest rate, for one bank to borrow from another, it will make the banks less likely to borrow, and therefore less likely to lend money, as well as decreasing the interest you earn on your bank accounts. For a more detailed explanation of the Federal Reserve and its role, see here

.
One last thing to note about interest: most of the interest you deal with in your life will be compounded interest. Remembering back to eighth grade math, compounding is the process in which the accumulated interest amount is added back to the principle, so that you earn interest on your interest. It sounds confusing, but this graph (assuming a 50 percent interest rate) should help:

 

Overall, you should be aware of the various rates that affect you—your credit card's APR, your saving's account rate, your student loan rate. Make a chart detailing what each of the rates are, and if you notice that you are earning drastically less interest than you are paying, you may want to change some things around—open an online savings account with a higher interest rate, or reduce the balance on your credit cards. Ideally, you'll want to earn enough interest to at least keep pace with inflation—but that's a topic for next time! In the meantime, start to pay attention to the ways interest affects you; they are much more numerous than you might think.


Share this post