Interest is something we all pay or earn at some point in our lives.
If you have ever owned a savings account, credit card or a loan you would have encountered interest.
Whether you are earning it (via a savings account or term deposit) or paying it (via a credit card or loan) the calculation for the interest which is applied is basically the same.
It involves 3 things:
- The Balance
- The Interest Rate
- The Term
Interest is usually calculated on daily balances and is credited or debited monthly, although this can vary depending on the financial institution.
To see how interest works in the real world, we will look at two examples: the first is how interest is charged on a credit card; and the second, how it applies to a savings account.
Let's say Ashley owns a credit card with an interest rate of 16.5% pa and a current balance of $2,300.
To make this calculation as easy as possible we will look at the month of June, which has 30 days. The number of days is important as you will see.
We are also going to assume Ashley won't be using her credit card during the month so the balance will stay the same throughout the month.
The calculation is as follows:
Monthly Interest = Daily Balance x Daily Rate x Number of Days in the Month
In our example, this would be as follows:
Monthly Interest = $2300 x 0.000452* x 30 = $31.19
* This is the daily rate. That is, the 16.5% annual rate divided by 365 (for the number of days in the year).
If you divide 16.5% by 365 you get 0.045% - the daily percentage rate. But you need to move the decimal two places as you are converting it from a percentage to a number.
As you can see, Ashley would be paying $31.19 in the interest in the month of June.
This same formula applies to your savings account as well.
Ashley also has an online savings account which is earning her 3.5% pa interest. She has amassed a balance of $1950 after some serious saving on her part.
We use the same formula:
Monthly Interest = $1950 x 0.0000959 x 30 = $5.61
Ashley would earn $5.61 on her balance of $1950 for a total of $1955.61 at the end of June.
Now you know how interest is calculated you will be able to apply this to your own accounts and loans.
Just remember that each month will vary depending on your daily balance and how many days are in the week. Interest can also change if it happens to be a leap year as there are 366 days in the year.
Remember, this calculation can be applied to other loans like your mortgage or any store finance you have as well - pretty much wherever interest is applied.
Does this help you understand interest rates better?
Please note this is not financial advice and it is recommended you seek professional advice before making any decisions regarding your finances.
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