A New Interest in Interest

In this day and age, interest is almost synonymous with purchasing. We have come to accept the notion that we should pay interest on purchases, such as:  homes, vehicles, electronics, clothing, and even the pursuit of a higher education. We have short and long term goals that we believe require immediate finances, so we pursue loans from banks and other financing organizations that promise to loan us money as long as we promise to pay them back more than what they've lent us.

Most of our grandparents, and even some of our parents reserved their spending for items and ideas they could afford in cold, hard cash. Those who were able to use store credit did so on the basis of trading goods for services or because their integrity provided the confidence a business owner needed as evidence that they would settle their accounts. Therefore, it was unnecessary for businesses to charge them interest.

The concept of paying interest for something today that could be saved for and obtained later was a foreign concept to many of our forefathers. So, why have we decided to think about money and handle it differently than our wise ancestors? There are many reasons, but the most important one is the fact that we have come to believe that interest is an expected and acceptable part of our purchasing power. We are willing to pay simple interest to have items today that we could easily purchase outright if we were to budget for them over the course of a few months, and we volunteer to pay compound interest on substantial purchases that would otherwise necessitate exercising discipline to work hard and save for them over the course of a few years.

Let's take a closer look at how simple interest and compound interest works. Remember the twins, Michelle and Morgan from last Monday's checkbook register game? Well, today I'd like to use them in this exercise. Take a look.

Simple Interest

Simple interest rates allow companies to make a profit on the amount that is borrowed from them based on the principle value. For example, Morgan borrows $1,000.00 at a rate of 15% per year on simple interest. This requires her to pay an additional $150.00 at the end of each year she still owes on the loan. Suppose it takes her 5 years to pay the loan in full? Look what happens:

Year 1 - $1,150.00 owed
Year 2 - $1,300.00 owed
Year 3 - $1,450.00 owed
Year 4 - $1,600.00 owed
Year 5 - $1,750.00 owed

At the end of that loan, she will have paid $750.00 in interest for the $1,000.00 she initially borrowed. Would her immediate need to make a purchase be worth paying 75% more for it in the long run? Absolutely not! Even if she paid it off at the end of 2 years, it's highly unlikely that Morgan couldn't have otherwise avoided shelling out $300.00 in interest. Lack of planning and refusing to deny herself are the more likely culprits.

Compound Interest

Compound interest rates work quite differently from simple interest rates because these rates build dramatically over time. Compound interest rates allow the financing company to not only charge interest on the principle value, but on the value of any previous accrued interest as well. Using the same scenario from above, Michelle would not only be responsible for paying $150.00 after the first year of the loan. Every year after that, she would be responsible for paying 15% on the entire loan. Look closely:

Year 1 - $1,150.00 owed
Year 2 - $1,322.50 owed
Year 3 - $1,520.88 owed
Year 4 - $1,749.01 owed
Year 5 - $2,011.36 owed

So, at the end of 5 years, Michelle will have paid a total of $1,011.36 to borrow $1,000.00. She will have paid back more than double the amount she initially borrowed! Does that make sense to you? Yet, we are choosing business deals like this one every day because we fail to budget, fail to save, and refuse to deny ourselves what we want right now.

ONE LAST THOUGHT

Go back and look at the 2 scenarios I've provided above. Now, suppose we weren't talking about interest payments Morgan and Michelle made on loans from institutions, but rather, suppose we were focusing in on interest deposits made to these girls from savings and investment organizations? In that case, Morgan will have earned $750.00 on her initial investment of $1,000.00 in 5 years, and Michelle will have earned $1,011.36 on her initial investment of $1,000.00 in 5 years. Now, who would have a problem with that?

So, on the one hand, simple and compound interest can have an adverse effect on your financial portfolio, and on the other hand, they can have a positive effect on it. It all depends on which one you're more interested in. If you're more interested in paying more for purchases than they're worth (which I don't believe you are), and working hard for your money, then keep using those credit cards and leaving balances on them. However, if you're more interested in making your money grow (which you should be), and watching your money work hard for you, then put your money where your interest is!

I really hope you've learned something new today about your money and the way you think about interest. Let's stop investing it in quick, credit purchases that yield profits for our lenders, and instead change our focus and start investing it in savings and other long-term, wealth building transactions that will enable us to receive interest rather than to pay interest. I believe in you and I know you believe in me, so let's challenge ourselves to change how we handle our money and other people's money RIGHT NOW!

Have a Mind-changing Monday!