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Interested in Interest?

What you should know about interest.

Are you interested in interest? You should be because interest allows you to make money by simply letting it sit in your account. On the other hand, if you owe money, interest will keep adding to what you owe. Here are a few things you should know about interest and how you can help make it work for you.

What is interest?

Simply put, interest is a portion of money paid on a balance. The money you have in your savings account is a balance. If you borrow money, the amount you must pay back is a balance.

For example: If you have $100 in your savings account and an interest rate of 1%, after your interest is calculated you’ll have $101. That one dollar is your interest earned.young kid holding cash

Not all interest is the same

There are three types of interest: simple interest, accrued interest, and compound interest.

  • Simple interest is calculated off of your principal, the base amount of the amount you put in your account, or the original amount of the loan. The example above is simple interest. Simple interest is usually paid out at the end of a given term, like a month or a quarter of a year.
      
  • Accrued interest means interest is added until the end of the period. So if you have $100 and the loan accrues 1% per week, at the end of the month you’d have $104.
      
  • Compound interest is interest paid on interest. While simple and accrued interest are only calculated off the principal (the initial amount of the loan or deposit), compound interest adds the interest to the principal and recalculates the amount.

Each type of interest has its benefits and its downsides. You’ll have a hard time finding a loan that isn’t calculated using compound interest. That’s something to think about when you borrow money—you’re going to be paying interest on the interest.

As mentioned before, though, you’ll also earn interest when you deposit money into your savings account. The more you deposit, the more interest you earn. And since most savings accounts are compounding interest, you’ll earn money on the money you already earned by saving!

Why do you get paid interest?

You get paid interest on your savings account because your credit union actually uses the money you deposit. The more your credit union has in savings accounts, the more they can offer in loans. The credit union uses your money to loan out to others, paying you back when they pay their loan interest. Your money never really goes anywhere, and the full amount can be taken out at any time, but this is a very simplified explanation. Credit unions back loans based on you backing them by trusting the credit union to safely store your money. And in turn, the credit union pays you interest.

How do loans work?

Loans are borrowed money. Theoretically, you should be paying less and less each time because the amount is going down if you pay each month. However, some loans are structured in a way that the principal, the initial amount of the loan, isn’t paid until you’ve paid interest first. That means even if you were to pay off the loan early, the interest was already calculated for the life of the loan. So even after one day, you’ll owe the full amount of the loan and the full amount of the interest calculated over the full life of the loan.

In the end, interest is either a reward for depositing money or what you pay to borrow money. There are plenty of calculators out there that you can play with to understand interest more. Hopefully, this helped you understand why saving is important and why you should read the fine print on any loan.

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