29 June 2012

Are You Interested?

What is Interest?
A topic that comes up without fail on virtually any financial discussion is the topic of interest. There are a plethora of guides out there with information on all kinds of interest. But before we get into a deep discussion about it, it might be worthwhile to understand it from a purely philosophical perspective, no math involved. At its core, interest is paying for money. Jewish law [Leviticus 25:36] forbade the charging of interest, and that practice was passed into Christianity as well. Islam [Quran 2:275] also frowns upon interest. Interest-free (riba-free) loans are still very prominent in both Jewish and Muslim society, but Christianity turned to usury several centuries ago. (Note that although "usury" now is an unsavory part of speech, it was originally just another word for "interest".) Since much of the modern world was conquered by Catholics/Protestants (i.e. not Jews or Muslims), the modern world loves interest. Even when offering interest-free loans, most institutions today refer to them as having 0% interest, not being interest-free.
With that smattering of background on interest, let's explore a little more. As has already been established, interest is a charge for borrowing money. In the case of your savings account, the bank is paying you to use your money. When you buy a car, the reverse happens: you pay the bank for borrowing the money to buy the car. Interest rates are usually described in terms of the percentage of the amount being paid yearly, better known as an annual percentage rate (APR). Those rates start at 0% APR and extend upward really toward infinity, though most commercial rates stop in the 200% range.

Compound Interest...
Interest rates come in two flavors: simple and compound. As the name implies, simple interest isn't very hard to calculate and is also much easier to pay if it is applied to your debt. In simple interest, the APR is applied only to any initial principal, no matter how long the balance is outstanding. This differs from compound, where the APR is applied to the initial principal as well as to any interest that has been added to the principal. That process is called compounding, and is the type of interest in use in basically all business transactions today.
Compound interest is sometimes called the "8th wonder of the world" due to the growth potential of a relatively small amount of principal. As this isn't a math class, I won't post lengthy derivations of formulas. However, PERT is one of the most important formulas to remember. PERT will calculate the value of a given amount of money plus any interest compounded annually. Total ammount = principal x exponential function (e) ^ rate x time (years). On a related note, dividing 70 by the interest rate will give the doubling time of a given quantity (applicable to anything that grows exponentially, not just money). For example, a typical savings account rate for a high-yield account now is around 0.70% APR. At that rate, expect to leave your money there for 100 years if you want to see it double.

...Can Be Good...
Despite the dismal example at the end of the last paragraph of savings growth, don't discard all saving as worthless. While it is true that depositing a set sum and then leaving it might result in a lifetime to grow, making regular contributions will greatly reduce the time necessary for the growth the occur. Additionally, regularly putting contributions quickly raises the P from the PERT formula. At first, growth seems to go rather slow. But with a little commitment, the money contributed will reach a point where growth equals then subsequently exceeds contributions. Making modest contributions now can turn out quite handsomely in the future, even with what appears to be a dismal savings rate.

...Or Very Bad
In contrast to when interest is working for you in a savings or investment account, interest working against you isn't optimal for your finances. The very same formulas and methods banks use to pay you interest on your savings account are now turned against you when money is financed. This effect is amplified because loans are the income that pays your bank account interest, so the interest rate charged is higher than what would be received in a savings account. Differences can be multiples of ten and can easily be by factors of several hundred. So while deciding that the 0.10% APR the local bank pays on savings accounts isn't worth it, simultaneously deciding that a 6.5% auto loan is a "pretty good deal" is actually very counter-productive. Not only does that auto loan charge double current inflation as an interest rate, it also reduces the amount available for depositing elsewhere.
Even worse are offers for rates in the teens and into the mid-20% range. Even at "19.99%" APR, the balance will double every 3.5 years from interest alone. Considering that minimum payments are typically only 2.5% of balance, that means a year of minimum payments will be equal to at most 30% of balance. But wait! Since interest is 20% of total balance, 2/3 of the yearly payments are actually going to pay for the interest, not toward the debt itself. So in best case scenario, only 10% is going towards the balance. Then, since interest is 2.5% of balance, not just a fixed amount, the minimum payment drops as the balance slowly creeps downward. (Although there usually is an absolute minimum of $20 or so if 2.5% of balance is lower than that.) Avoid the inherent trap this creates. By lowering the payment with the lowering balance, maximum profit for the company is assured. While it would theoretically take around four years to retire a debt that was interest-free, diverting 2/3 of your payment toward interest then dropping the minimum extends the time almost indefinitely and also result in far more than the original amount being paid in the long run.
Here's a calculator that helps you figure out a payback time for balances at various APRs

When to Use Interest
With all that background, interest does have a time and place to be used. Certainly, you should look to get the best APR on your savings. While perpetually hopping around looking for a good rate may not be worth the hassle, looking into getting something decent from the very beginning will be very helpful. Also, keeping lots of money in a savings account really isn't necessary, but I'll talk about that more later. But by not storing the money in a savings account, it becomes possible to put it in places that result in much higher APR being earned. Again, those places will be talked about later.
However, I believe using interest as a consumer has far fewer legitimate applications. Using interest to pay for things robs you of the ability to do what you want to do. The few places where interest might be worthwhile are in buying a home and paying for school. Buying a home is on the list because it can save you money if you do it smartly. There's always a raging debate about whether buying a home is a good idea or not and a dizzying amount of calculators dedicated to the subject. I won't even wade into the fray at the moment, but will say that make sure you buy a house you can afford. Just because the bank has approved you for a loan of x amount of dollars total doesn't mean you need to then find a house that completely uses that amount. Also, if the loan would be more then triple annual salary, politely say refuse because you actually can't afford it.
Paying for education falls on the list because most people entering college don't have several tens of thousands of dollars sitting around. However, great pains should still be taken to minimize the amount borrowed to skip lecture. Despite the national uproar as of late about students loans, they really aren't as bad as they sound. Unfortunately, a fundamental misunderstanding still exists concerning averages and medians which is used to fan the flames of the issue. While sure, the average student loan balance is indeed ~$25k, the median (i.e. the actual halfway point) is only about half that, or around $13k. A good majority of people have less than $20k worth of student loans. I dare say it gets skewed upwards by the Harvard grads who studied investigative journalism of the life cycle of the New Delhi Sand Fly. They make it sound worse than it is, because $13k really is not impossible to pay off in a reasonable amount of time. At a future post, I'll explain myself more on that and expand more on education.
That's it. Again, those two scenarios exist really due to the fact that it's often impossible to gather the required funds in a timely manner for those two activities. For everything else, a reasonable timescale exists to save the money to buy it. Usually, saving and paying cash comes out much cheaper in the long run and even immediate benefits can usually be seen by not spending money. Having money available when necessary creates a peace-of-mind, relieves a lot of stress, and leads to all kinds of freedom. I can already hear the choruses about how other situations require credit. No. They don't. If you have to use credit, you probably can't afford it. Also, credit reduces how much money you can spend, so that things you could have been able to buy if only you'd saved a little are now out of reach. I've personally seen that effect firsthand on my finances, although it has taken me a long time to realize the true consequences. Now that I'm finally looking at it with a new light, I'm now intent on paying off all my accounts ASAP.

Further Exploration

This video is a tidy summary of interest's effects on finances.

This video explains the difference between the two types of interest.

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