Evil Interest

Everybody with a savings account or almost any form of debt has at least a passing familiarity with interest.   How many of you actually know what it is, or even how much you are actually paying?

Debt

First, some definitions.

Principal is the term used for the amount of money you have borrowed.

Interest is the rent you pay to have that money.   Interest is money-rent, expressed as a percentage of the principal.  If you borrow $100 at 10%, you pay approximately $10 in interest.   I say “approximately” because it’s just not that simple.

There are two kinds of interest: simple and compound.

Simple interest is called that because it is just that: simple.   It’s easy to understand and it’s what most people mistakenly assume they are paying.  With simple interest, the interest rate is only applied to the principal, never to the accumulated, or accrued, interest.

For example, if you have borrowed $100 at 10% annual interest, this is what your balance will look like:

  • At the time of borrowing the money, you owe $100.
  • After 1 year, you owe 10% of the $100, in addition to the original $100: $110.
  • After 2 years, you owe 10% of the $100, in addition to the original $100 and year one’s interest: $120.
  • After 10 years, you will owe a total of $200.

That’s simple.

On the other hand, in addition to five more fingers, you have compound interest.   Compound interest complicates things considerably. With compound interest, interest is applied to the entire balance of what you owe; both the principal and the accrued interest are included in the calculation.

For example, with $100 at 10% compounded annually:

  • Year 1: You will owe $100 + 10% of the original $100, or $110
  • Year 2: You will owe $110 + 10% of the $110, or $121
  • Year 3: You will owe $121 + 10% of the $110, or $133.10
  • Year 4: You will owe $131.10 + 10% of the $110, or $144.41
  • Year 5: You will owe $144.41 + 10% of the $110, or $158.85
  • Year 6: You will owe $158.85+ 10% of the $110, or $174.74
  • Year 7: You will owe $174.74 + 10% of the $110, or $192.21
  • Year 8: You will owe $192.21 + 10% of the $110, or $211.43
  • Year 9: You will owe $211.43 + 10% of the $110, or $232.57
  • Year 10: You will owe $232.57 + 10% of the $110, or $255.83

That is a total of $155.83 in interest paid over 10 years, or $15.58 per year, for an effective interest rate of 15.583%.

To throw another twist into the mix, interest is rarely compounded annually.  Monthly, or even daily, is much more common.   With monthly compounded interest, the annual rate, or APR, is divided by 12 and recalculated every month.

For example, using the same $100 at 10% APR, compounded monthly:

Since the interest rate is compounded monthly, we will be using the monthly periodic rate, which is 10% / 12, or .83%

  • Month 1: $100 + .83% of $100 = $100.83
  • Month 2: $100.83 + .83%  = $101.67
  • Month 3: $101.67 + .83% = $102.51
  • Month 4: $102.51 + .83% = $103.36
  • Month 5: $103.36 + .83% = $104.22
  • Month 6: $104.22 + .83% = $105.08
  • Month 7: $105.08 + .83% = $105.95
  • Month 8: $105.95 + .83% = $106.83
  • Month 9: $106.83 + .83% = $107.72
  • Month 10: $107.72 + .83% = $108.61
  • Month 11: $108.61 + .83% = $109.51
  • Month 12: $109.51 + .83% = $110.42

That’s $0.42 more interest paid the first year, and that number will continue to climb each year the interest is compounded.

It gets worse if interest is compounded daily, like most credit cards.   If you see “Daily Periodic Rate” anywhere in your agreement, you are getting compounded daily.   This same loan, compounded daily instead of monthly will yield $110.51 owed the first year.   That $0.51 might not seem like much, but imagine it on a $10,000 credit card, or a $100,000 house!  And that’s just the first year.   Every year after, the disparity gets bigger.

Edit: The formula for calculating compounding interest is Principal x (1 + rate as a decimal / compounding term)compounding term. So, for $100 at 10% compounded monthly, the formula is 100 x (1 + 0.1 / 12)12

That’s the downside to compounding interest. There is an upside, if you have investments or interest-bearing accounts.   If that’s the case, compounding interest is working in your favor.

If you save $100 per week, and manage to get a 10% return on your investment, you will have $331,911 after 20 years(with $104,000 contributed)  and $2,784,424 after 40(with $208,000 contributed).   That mean you will have tripled your money in 20 years, or vingtupled* it in 40 years.

That’s how you get rich. $100 per week for the rest of your life will leave you with a comfortable retirement, without missing out on life now.

* Yes, it’s a real word**.  It means a twenty-fold increase.

** No, I did not know that yesterday.

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Repo Man

Here is a fun blast from the past.  This was originally posted in February 2010.

A few years ago, we bought a new truck.  We brought our old truck in as a trade, but the offer was bordering on insulting, so we kept it.

We posted the old truck on CarSoup, the classifieds, and anywhere else we could find to post it.  Nothing.  After a few weeks, we finally found a

http://www.flickr.com/photos/-evidence-/2063223009/

Repossession

buyer–a friend we had hired to help with a large remodel on our house.   He didn’t have all of the money to buy it, but we knew him, we knew his family, and he was work for us.  It should have been a low-risk loan.  We’d give him the truck, he’d make monthly payments.  Simple, right?

That was the plan.  He made payments for about six months.  When the starter died, we forgave that amount of the debt.  When we was short, we’d let him skip a payment.  Were were good lenders, at least from his perspective.

Then, “I’m a little short this month” stretched into two months, three, six.   Then one day, he fell off the face of the planet.  I found out later, he’d canceled his phone and left the state.  We were the kind of lenders that get banks closed down by bad business decisions.

What could we do?  Fortunately, we’d created a written loan agreement and entered ourselves as the loan holder during the title transfer.  I eventually filed the repossession payment…a year after he disappeared.  I figured, if by some chance the truck got impounded, we’d get it back.

A few months later, we were driving down the highway that just happened to pass within sight of his brother’s shop.  I just happened to glance in that direction as we drove past.  I’m sure I caught my wife by surprise with the sudden u-turn.  I found our truck.  The long-lost friend was back in the state, staying in his brother’s shop.

[caption id="" align="alignleft" width="196" caption=" "] [/caption]The next day, I brought another friend to the shop.  We knocked on the door.  No answer.  I left a note on the shop door and we took the truck, using the spare keys I kept when we sold it.  I had just completed my first–and so far, only–repossession.   I’m not a bank or a repo man, just a guy who got screwed.

Possession was mine.  Wrongs were righted.  The truck was tentatively sold immediately.  If the buyer couldn’t pay, the truck was gone.  He called, offering his apologies and hoping to get the truck back and start making payments again.   I accepted his apologies and kept the truck.   People are only allowed to rip me off once.  Almost two years without a payment or even an excuse is too much for me to accept.  So far, I am the only person I know to manage a legal repossession as a private party.

The repo process varies by state, but the basics don’t change much.  The loan holder can file for repossession as soon as the loan agreement is broken.  They can repossess with no notice and the borrower is on the hook for the difference between what’s owed and twhat’s recovered during resale.  If you get to the point of repossession, you are out of options.  You are generally left to pay the debt in full, or lose the vehicle.  If you are accepting payments from a friend to buy a car, make sure you have a written agreement and are listed as the loan holder on the title.  Keep some leverage to avoid getting screwed.

How far have you gone to recover money you are owed?

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Unsecured Personal Loans: Advice for First-Time Borrowers

One of the most difficult decisions you will have to make when applying for an unsecured personal loan is figuring out how much you should borrow and for how long. It is important to understand that the more you borrow, the more you will  save. How? Lenders will usually enforce higher interest rates for smaller loan amounts. Therefore, applying for more than you need is a great idea only if you can resist the urge of spending those additional funds. A good idea would be to take those extra funds and invest them into an appealing high interest money market or CD.

Determining how much you can afford

If you are not looking to borrow more than you need, we suggest utilizing the following input: Create a budget including all of your daily living expenses and monthly bills. Subtract the total of all your expenses from your monthly net income. The amount left over is not going to be what you can afford towards payment of an unsecured personal loan. Why? You don’t want to leave yourself without any emergency money. You never know when you may need some extra cash for an unforeseen situation like a car or home repair. 75% of the amount left over should be designated for monthly personal loan payments.

Determining how much to borrow

Evaluating the total intent of your loan is critical when calculating how much to borrow. For example, if you are planning a vacation, you will need to not only factor in the cost of the flight and the hotel, but also the costs of eating, drinking, sight-seeing, etc..

Determining how long to borrow

A loan term is the total length of time you have to repay your loan. Typical terms for unsecured personal loans range from 12 – 72 months. It is essential that you comprehend that the greater the duration of your term, the more costly your loan is going to be. With a longer term, your monthly loan payments are going to be lower, but the amount you pay in overall interest fees is going to be greater. But, it may make sense for you to make use of a longer term. For example, suppose the plumbing system in your new home stops working and needs to be immediately repaired. However, you moved in less than one year ago and have zero equity in the house. And, you are having a difficult time satisfying your existing monthly monetary obligations. For this type of situation, it makes sense to satisfy your immediate financial needs so that you can get your plumbing repaired without having to put too much additional strain on your wallet. Saving money is good, but keeping your sanity is better!

Determining where to apply

Your local bank is probably the first option that comes to mind. Don’t limit yourself. Take advantage of the internet. Online lenders, like Choice Personal Loans, compete with local banks by offering extremely competitive rates and terms for their unsecured personal loans.  They even offer no credit loans for those looking to establish their credit history.

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