By Emily Luong, student @ UCLA
You’ve probably heard the term "interest" a lot when it comes to credit cards, saving accounts and student loans. Simple and compounding interest is also something covered in most middle-school math classes. But how does it apply to real life? Is it good or bad for you? Turns out, interest can either work for you or against you.
Great Interest: Savings Accounts
Savings accounts with high APYs (annual percentage yield) can allow you to earn more free money through interest than the average savings account. This is calculated as compound interest, which means that the interest is calculated and added to your account balance more than once a year (typically daily or weekly). Once the interest is added to your account, you begin to earn even more interest on top of that new amount!
If you put $1,000 in a savings account with an APY of 1.6%, you can earn $16 at the end of the year through compound interest. All this for doing nothing but depositing your money into the account and leaving it there!
Bad Interest: Student Loans
Now, interest on debt and loans is where things go downhill. The same compounding interest effect that is so great for savings accounts can really hurt you when it comes to loans, especially large student loans. It causes you to have to pay back an amount larger than what you initially borrowed.
Let’s say you took out $10,000 in unsubsidized loans from the Department of Education when the interest rate was 4.45% , and stay in school for 4 years. You don’t pay off any of the loan while in college.
When you graduate and start your repayment plan, you realize the balance is now $11,936.52 instead of $10,000. Almost $2,000 more than you initially borrowed! Why? Because you didn’t make any payments in college, interest has been piling up on your $10,000 loan balance for the past 4 years.
As you make your monthly payments post-graduation, compound interest continues to work its evil magic on your inflated balance. It snowballs until you end up having to pay back $14,810.40 in total. That’s nearly $5,000 more than your initial loan balance!
So how do you avoid paying back more than you have to?
Pay off the accruing interest on your loan balance while you’re still in school.
This way, when interest is calculated, it’s only calculated on the initial $10,000 and not any additional interest added on throughout the 4 years.
If you make regular payments during school, you’d only pay $1,780 in interest for your 4 years in college. After graduating, you’d end up paying back an additional $2,408 in interest — for a total of $14,188 paid off. You’d save over $600 by paying off interest during school! Now think about what you could do with an additional $600…
A good resource to automatically calculate different scenarios with your personal loan amounts is the Cost of Interest Capitalization Calculator.
Bad Interest: Credit Cards
Credit card interest can be even worse than student loan interest — especially because their interest rates are typically much, much higher! For example, the Discover it Card for Students (a popular first credit card for college students) has an APR of 14.49% to 23.49%, depending on your credit history. This is a stark contrast to the 4.45% interest rate for student loans.
This means that keeping a large balance on your credit card (not paying it back in full every month) greatly increases the amount you eventually have to pay back. That’s why we keep recommending you to limit your credit card spending to what you know you can pay back, and pay every month’s bill in full!
An urban legend claims that Albert Einstein once declared compounding interest to be the most powerful force in the universe. The jury is still out on whether he actually did, but the essence of the statement remains true. Interest is incredibly powerful and can either work for you or against you.