Do you know how interest rates are calculated on your bank accounts, credit cards, loans or mortgages? here’s how
Dubai: Knowing how interest is calculated can help you understand the true cost of your debt.
One of the first things you learn about money management is the concept of interest, which comes into play when you lend or borrow money.
Lenders earn interest on the money they lend, while borrowers pay interest on the money they borrow. Interest is a percentage of the money you borrow or lend that is paid periodically. While typically listed on an annual basis, the interest can last as long or as little as the lender requires.
The main types of interest and their real applications
The main types of interest include simple or regular interest, accrued or accrued interest, and compound interest. When money is borrowed, usually through a loan, the borrower is required to pay the interest agreed upon by both parties.
Simple interest is typically used for credit card loans, car loans, student loans, consumer loans, and sometimes even mortgages. On the other hand, compound interest is often used to increase returns on long term investments like investments.
Another common use of compound interest is in bank accounts, especially savings accounts. Student loans, mortgages, and credit cards can also use compound interest, so be sure to keep an eye on the interest rate when making big financial decisions like these.
There aren’t any hard and fast rules for determining which purchases constitute simple or compound interest, so be sure to ask your lender or do your research before borrowing any money. Understanding simple and compound interest is invaluable in helping you take control of your finances.
Whenever you borrow money, it is very likely that interest rates are involved. So it is even more important to understand the ins and outs of interest and how to maximize the management of your money.
Review the basics of interest rates
Simple or regular interest is the amount of interest owed on the loan, based on the outstanding principal of the loan (that is, the amount originally borrowed).
For example, if a person borrows 2,000 Dh with an annual interest rate of 3%, the loan will require an interest payment of 60 Dh per year (2,000 Dh (multiplied by) 3% (3/100) = 60 Dh).
Accrued interest is accrued interest that is unpaid until the end of the period. If a loan requires monthly payments (at the end of each month), interest accumulates regularly throughout the month.
For example, if 30 Dh is the interest charge each month, the loan accumulates 1 Dh of interest each day which must be paid once the end of the month is reached. In this example, on day 15, the loan will have accumulated Dh15 of accrued interest (but will require payment once Dh30 is reached).
Key difference between simple interest and accrued interest
The difference between these two types of interest is that regular interest is paid periodically (determined by the loan agreement) and accrued interest continues to be owed to the lender over time.
Compound interest basically means “interest on interest”. Interest payments change with each period instead of remaining fixed. Simple interest is based solely on the principal outstanding, while compound interest uses principal and previously earned interest.
If a person borrowed Dh1,000 with 2 percent interest and has Dh100 accrued interest, then the interest for that year would be Dh22. This is because interest is paid on the principal (i.e. the original borrowed amount of Dh1000) and accrued interest (Dh100), for a total of Dh1100. 2 percent (2/100) of Dh1100 is Dh22.
Key difference (simple interest vs compound interest)
If you put 5,000 Dh into a bank account that earns 4% interest per year, you will have 5,200 Dh by the end of the year. Now, if you keep the 5,200 Dh in the bank for another year, you will have 5,408 Dh.
Simple interest: Simple interest would be equivalent to receiving 5,200 Dh after the first year, withdrawing 200 Dh, then having 5,000 Dh before the following period. Each period, the individual will receive Dh200.
Compound Interest: Compound interest would increase interest payments since you receive interest on your interest.
If the individual left 5,200 Dh in his bank account, he would have 5,408 Dh at the end of the following period (which represents a gain of 208 Dh instead of 200 Dh with simple interest). It shows the power of compound interest.
How is credit card interest calculated?
If your credit card has an annual percentage rate of, say, 18 percent, that doesn’t mean you’re paying 18 percent interest once a year.
Depending on how you manage your account, your effective interest rate may be higher or lower. This is because interest is calculated daily, not annually, and is only billed if you have month-to-month debt.
Your interest rate is identified on your credit card statement as the annual percentage rate, or APR. Since interest is calculated daily, you will need to convert the APR to a daily rate. Do this by dividing by 365. The result is called the periodic interest rate, or sometimes the daily periodic rate.
Understanding the APR or the annual percentage rate
Interest rates are usually given as an annual percentage (APR) – the total interest that will be paid in the year. If interest is paid in smaller time frames, the APR will be divided.
For example, a 6 percent APR paid monthly would be divided into twelve 0.5 percent payments. (6/12 = 0.5). A 4 percent annual rate paid quarterly would be divided into four 1 percent payments. (4/4 = 1)
What interest rates do credit card issuers use?
Most of us know that our credit cards have a stated interest rate, and that’s the amount of interest our balance would generate over the course of a year if we didn’t pay it off at all. . This is called the APR or annual percentage rate.
At first glance, then, you might expect a Dh1,000 credit card with an APR of 29.9% to generate interest charges of Dh299 over a year, right? No. After one year, your credit card balance would actually be Dh 1,353.95. So where does this Dh54.95 supplement come from? It came from the daily composition.
Most credit card issuers Interest compound daily. This means that your interest is added to your (original) principal balance at the end of each day. If your credit card has an annual percentage rate of, say, 18 percent, that doesn’t mean you’re paying 18 percent interest once a year.
Depending on how you manage your account, your effective interest rate may be higher or lower. It could even be 0 percent. This is because interest is calculated daily, not annually, and is only billed if you have month-to-month debt.
Let’s say you have a card with a 20 percent rate. To convert this to a daily rate, simply divide 20 percent by 365.
Keep in mind that you need to convert the percentage to a decimal first, so divide it by 100. Your daily rate would be 0.0000555, and that’s how much it’s made up of.
Here’s how to beat daily compound interest on credit cards
Having a balance on your credit card past the due date on your statement is even worse than you might think. Not only does it start accumulating interest at this point, but you lose your grace period (which is the period between sending your credit card statement and the due date), which means new spending on your card start earning interest immediately.
As soon as you do not fully repay your card by the due date, this grace period disappears. Instead, the purchases you make on your credit card start earning interest immediately, as soon as you make them.
It makes a big difference. If you put 1000 Dh on your credit card at 29.9% interest, have no grace period in progress and do not pay it back for 30 days, you accumulate 25.22 Dh d ‘interest. It’s nailed right to the scales for it to keep growing and developing.
On the other hand, if you’ve paid off your entire credit card and have a grace period, you don’t owe any interest on that expense.
Restore your grace period by paying off the card in full for two consecutive months
Simply paying off your credit card will not get your grace period back. You have to do this twice in a row.
Indeed, even if you pay everything on your invoice, it still accumulates interest between the moment the invoice was sent to you and the moment you paid it. This additional accrued interest will appear on your next bill, which you will also need to repay in full for your grace period to be reinstated.
The solution is to pay off your credit card in full and keep it that way. Simply pay off your credit card balance two months in a row and your grace period is restored. Going forward, you won’t see any interest charges on your statement as long as you continue to pay all of your new charges in full.
At this point, a credit card becomes a practical tool rather than a source of debt. This makes many types of payment much easier, and if you have a good rewards program on your card, it accumulates rewards effortlessly. A good practice to make this easier for you is to only use your credit card for certain types of purchases.
What interest rates do personal loan issuers use?
Personal loans tend to offer lower rates than credit cards, and the repayment terms are fixed, which means you won’t have to worry about persistent debt.
Personal loan interest rates are expressed as a percentage of the amount you borrow. Interest on personal loans is usually calculated using the simple interest method, rather than compound interest.
With the simple interest method, the amount of interest increases depending on the amount you borrow, the interest rate, and the length of the loan.
If you borrowed 1000 Dh at a rate of 5% with a loan term of one year, you would pay 50 Dh in interest. If the term is extended to two years, the interest would double to reach 100 Dh.