## Step Two Continued: Understanding Interest Debts

**Understanding Interest Debts**Having debt is not a bad thing but, depending on the type of debt and how long the debt builds, it can negatively affect a budget. Understanding the cost of borrowing money is important. There are two main areas to consider before borrowing money: the interest rate and the loan duration.

*Interest rate*

When we see our interest rate, it's normally in the form of an APR. APR stands for Annual Percentage Rate, which is the yearly cost of borrowing money. Pretty simple, right? Well, sometimes.

There are two basic ways for lenders to calculate interest rates: simple interest and compound interest. Let's take a look at two loans governed by both. Each example includes a one-year loan for $1,000.00 at a 10% interest rate.

SIMPLE INTEREST

$1,000.00 x .10 = $100.00

Total debt: $1,100.00

COMPOUND INTEREST

$1,000.00 X .05 = $50

$1,050.00 x .05 = $52.50

Total debt: $1,102.50

$1,000.00 X .05 = $50

$1,050.00 x .05 = $52.50

Total debt: $1,102.50

**Simple Interest**Like its name, simple interest calculation is pretty simple. The interest charged is for the principal amount borrowed. If we borrow $1,000.00 at 10% APR for three years, we will pay 10% each year for the original amount borrowed.

Principal x rate x duration = total interest

$1,000.00 x .10 (10%) x 1 (years) = $100.00

$1,000.00 x .10 (10%) x 1 (years) = $100.00

**Compound Interest**Unlike the simple interest loan, compound interest is about balance or current principal.

When we look at a compound interest loan, we notice that the balance changes twice (semi-annually). This is because it hits what is called a compounding period, which is a new balance created from a previous interest. Therefore, interest is charged on a new, higher balance.

If the interest compound is more than once a year, then the APR must be converted into a periodic interest rate.

A periodic interest rate is calculated by dividing the APR by the number of compounding periods, which can include annually, semi-annually, quarterly, monthly, and daily.

**Formula for periodic rate:**

.10 (10% APR)/4 (quarterly) = 0.025

(periodic rate)

APR/compound periods = periodic rate

**Now, let's look at how the new balance is created:**$1,000.00 x .10 = 100.00 + $1,000.00 = $1,100.00

Current balance x periodic rate = interest + balance = new balance

Notice how compounding periods can change the amount of interest we pay.

This example is the end of year one of a $1,000.00 dollar loan at a 10% APR.

Annually - $100.00

Semi-Annually - $102.50

Quarterly - $103.81

Monthly - $104.71

Daily - $105.16

Semi-Annually - $102.50

Quarterly - $103.81

Monthly - $104.71

Daily - $105.16

Although the amounts seem small, we can see how just changing the compounding periods can change how much we pay for the same amount borrowed.

Compound interest is fantastic for our investments but isn't so great for our debt. However, compound interest does have a weakness: By paying more than what is due, we can shrink the balance and, therefore, owe less to charge interest on.

Compound interest is fantastic for our investments but isn't so great for our debt. However, compound interest does have a weakness: By paying more than what is due, we can shrink the balance and, therefore, owe less to charge interest on.

**Loan duration**The second most important part of borrowing money is considering the length or duration of the loan.

There are two basic types of loans in terms of duration: installment and revolving. Installment loans have a start date and an end date and involve regular payments, while revolving loans are lines of credit that have no start or end dates and have a minimum payment (normally 3% of the balance) rather than a set payment.

NOTE:

It is wise to not mistake an installment loan for a simple interest loan, as installment loans can also have compounding periods.

It is wise to not mistake an installment loan for a simple interest loan, as installment loans can also have compounding periods.

The length or duration of the loan determines how much interest will be paid over the life of the loan. If we borrow $10,000 for one year (12 months), we only pay interest for one year. However, if we borrow $10,000 for five years (60 months), then the costs can start to outweigh the benefits of the loan.

**How the Length and Interest Rate of the Loan Changes the Debt Amount**This table shows how much the interest rate and time can change the amount we pay.

For this example, the loan amount is $1,000.

APR |
3-year loan(36 months) Total Interest Paid |
5-year loan(60 months) Total Interest Paid |

6%
11% 17% 21% |
$97
$177 $280 $352 |
$163
$300 $352 $626 |

NOTE:

This example is of an annually compounded loan. If we added monthly or daily compounding periods, the numbers would increase even more.

We can see how the interest rate and the loan duration can be very important when considering the total amount we pay for the same amount of money borrowed.

We can see how the interest rate and the loan duration can be very important when considering the total amount we pay for the same amount of money borrowed.