Working alongside auditors during my accounting internship taught me that financial statements tell a story about an organization, but understanding the concepts behind the numbers makes the information much more meaningful. While my internship focused on the auditing process, it also reinforced the importance of looking beyond calculations.
While technical expertise can build a career, understanding how money works builds long-term financial security. From buying a house to saving for retirement, being personally financially stable allows one to pursue their professional goals more aggressively. Gaining an understanding of how financial tools work and becoming financially literate is important for young professionals.
One of the major building blocks to sound financial literacy is understanding interest and interest rates. Interest operates behind the scenes on most transactions, whether it’s reviewing a company’s financial position or making personal financial decisions. Understanding how interest operates in practice provides important context for interpreting the numbers and making informed choices. This blog post focuses on several key concepts relating to interest.
Simple Interest
Defined simply, interest is the cost of borrowing money or the return for lending money to another party. Interest is either owed or earned through examples like taking on debt or lending out money respectively.
Interest is expressed across many different schedules of time. It is commonly seen as a yearly, monthly, weekly, or daily percentage of the principal, which is referred to as the interest rate. To calculate interest, you simply multiply the principal by the rate to find the interest owed or earned at each payment or collection period. With this basic understanding in mind, the following sections explain key factors that shape how interest works in practice.
Compound Interest
A common misconception is that growth stays the same year-over-year, growing with roughly the same expected interest each year, month, or day. However, many financial products use compound interest, which causes balances to grow differently than with simple interest.
When Interest compounds, debt and savings grow exponentially, not linearly. Debt and savings grow at an accelerating rate over time rather than increasing by a fixed amount each year. Interest builds, not only on the principal, but also the interest gained each year. If a loan is outstanding for a long period of time, it will have accrued much more interest than expected at the outset. Interest may compound daily, monthly, annually or on any other schedule set in the debt agreement. For some forms of debt, compounding can increase total interest costs over time. However, many consumer loans, such as mortgages and auto loans, are amortized, meaning the amount of interest paid each year typically declines as the principal balance is reduced.
Compounding interest can also have a very beneficial effect on people. If money is lent to another party, the yearly interest grows over time. If all else is equal, money saved in a bank within a high-yield savings account earns more interest next year than the year before.
It is important to be aware of the impact of compounding interest when evaluating financial decisions. What might appear like a small interest rate initially can result in much more than expected because of compounding interest. When dealing with debt, compounding interest can mean more accrued interest each year. Thankfully, when saving or lending, interest grows more and more each year.
The Role of Time
Understanding time’s effect on compounding interest is also imperative. The length of loan duration or savings period largely affects the total interest paid or earned. Due to compounding interest, the longer a loan is outstanding or money is lent, the more interest there will be. Compounding interest, along with time, can have a negative or positive impact on all financial decisions, depending on whether money is borrowed or lent.
Interest will grow exponentially over time, resulting in a larger balance the longer a loan is outstanding. Generally speaking, a 15-year mortgage results in considerably less total interest paid than a 30-year mortgage. The interest on a 30-year mortgage has much more time to accrue than the 15-year mortgage, meaning even if both loans had the same interest rate and original amount borrowed, the 30-year mortgage pays a higher amount of interest over the life of the loan.
APR v APY
Another important factor in understanding interest rates is the terminology used to expressed them. Most commonly, the interest rate is expressed as a yearly rate, referred to as APR (annual percentage rate) or APY (annual percentage yield). APR represents the total yearly cost of borrowing money, and APY is the total annual interest earned on savings accounts and certain investments, adjusted for compounding interest.
To simplify, APR is most commonly used for borrowing products such as mortgages, credit cards, or auto loans, while APY is commonly used for savings and deposit accounts. A key distinction is that APY reflects the effects of compounding, whereas APR generally does not. As a result, two accounts with the same nominal rate can have different APYs if they compound at different frequencies.
This distinction is crucial to understand as these are the rates commonly seen everywhere. Simply understanding these definitions lets people know whether they are lending or borrowing, and how much interest accumulates each year.
Final Thoughts
Interest should be considered in many of the financial decisions we make. From getting out of debt, loaning money to a friend, or buying a home, grasping how interest affects financial choices can help you evaluate different alternatives.
Financial literacy is not something that is acquired quickly. The knowledge is constantly built upon and grown over time. Improving one’s understanding of the underlying ideas behind how money works allows for making better overall decision.
Not everyone wants to study accounting or become an auditor, but becoming financially literate is possible (and essential) for everyone. The effort it takes to learn about the foundational concepts, like interest, will pay off in the long run.
