Guide to Interest, Fees and Your Life

Fees and Interest

Okay, we all pretty much know what interest is. It’s the price you pay to borrow someone else’s money. We could go into how interest is charged, how often it accrues and so forth, but that’s not the point here. The point here is how to judge interest rates versus fees and other financial costs.

In a nutshell, interest is charged as a percentage of the amount you borrow.

• So for a simple interest loan, if you borrow $1000 at 10% annual interest, you will pay $100 a year in interest, or approximately $8.33 per month in interest.

Now of course, it’s much more complex, because if you’re also paying down your debt, then your interest goes down each month. If you don’t pay, then the interest is added to your debt and next month you pay interest on your interest as well as principal.

Here’s the simple way to look at it: interest is a necessary evil. We’d all love to borrow money with no interest, but nobody would lend it to us. So if we want to borrow money, we have to live with interest.

• Given that, lower is better. An interest rate of X% will almost always cost you more than an interest rate of X% - 5.

In fact, lower is so much better that many people pay a fee up front to get lower interest - and they’re usually right to do so. You may have heard of "points" on a mortgage. That’s paying a fee to get a lower rate.

• For instance, you may find a loan at Prime Rate + 3% or a loan at Prime Rate +1% with a 7% one-time "origination" fee.

The second loan is probably a better deal. "How can it be a better deal? 7% sounds like a lot!"

Well, it sounds like a lot, but remember that you pay it once, up front, to get a lower interest rate. On the other hand, the interest you pay is paid month after month, year after year until the loan is paid off. The fee is paid once; the interest is paid over and over.

• Now obviously, you have to do the math. Paying a 200% fee to get 1% less in interest isn't a good deal.

So right about now, you’re probably thinking that something is missing. That we don’t want to explain the math behind interest. Well, no, the problem is really that the actual math is pretty obnoxious, and there are about 17 jillion different formulas for various interest methods.

For example, here’s just one. This is how you’d calculate a debt of $1,000, held for 15 days, then paid off, if you were using the Average Daily Balance method:

If you were using another method, it would be a whole different formula.

Aha! But this is your lucky day. We have a solution! At least as far as student loans are concerned, we’ve created a loan payment calculator that can let you try your different options and see what the result is. Just click here to give it a try.