I want to pay down my debt, but… do I really have to pay that much interest?

Interest: it’s in yours to understand how much you pay.

Money, it’s complicated and lots of us would rather bury our heads in the sand then try to figure it out. But being financially healthy means you need to understand the basics of how all of this works and how much you pay. Of course, going to a trusted financial advisor is still a good idea but at the very least you should understand the basics so you can know when you are getting good advice and making sound financial decisions.

Let’s start with interest – or as it can also be called, the time value of money. When you borrow money from any financial institution, regardless of the type of product, you will be given an interest rate. This rate determines how much you will pay the lender for borrowing their money.

Simple Interest = $ Borrowed x Interest Rate
If you borrowed $10,000 at 3% on an annual basis you will pay the financial institution $300 annually plus the original $10,000 you borrowed.

When it comes to determining your interest it depends on the product you are looking at as each product is a little different.

Fixed Interest and Term
This is typically for a car loan or mortgage and is called an installment loan as you pay the full amount owing (balance plus interest) in set payments over a set frequency. To calculate the total amount of your repayment you need to complete two steps:

Step 1: Calculate the total amount of interest by multiplying the amount you borrow, known as the principal, by the interest rate and then by the loan term in years. For example, you borrow $175,000 for your mortgage at 5% amortized over 15 years.

$175,000 x .05 X 15 = $131,250

Step 2: The total amount of repayment is equal to the interest plus the loan principal.

$175,000 + $131,250 = $306,250

Since interest is calculated monthly, if you are able to take your monthly payment amount and pay half every 2 weeks you will end up paying less interest as every payment is made up of a principal and interest payment. By saving on interest you will also pay off your mortgage or personal loan sooner.

Credit Cards and LOCs
These are revolving loans as the amount you borrow changes from month to month. To calculate the interest you are being charged you need to complete two steps:

Step 1: Find the interest rate on your statement. Say it’s 11.9% – this is the annual interest rate. Then determine your monthly interest rate by taking the 11.9% and dividing it by 12 (11.9% ÷ 12 = .992%).

Step 2: To get the interest you will pay on the monthly balance of $1,500 you multiply the balance by the monthly interest rate ($1,500 x .00992 = $14.88). If your minimum monthly payment is 3% of your balance ($1,500 x .03 = $45). This means of your $45 minimum payment, $14.88 will go to interest and $30.12 will go to pay down your balance.

If you do not charge anymore your balance next month will be $1,469.88 ($1,500 – $30.12). Since only a portion of your loan payment goes to the principal you can see how long it can take to pay off the original $1,500 balance.

In reality, credit card companies calculate your interest owing on a daily basis based on your balance. So if you carry a balance, by waiting to make your payment until the due date, you are paying more interest than necessary. To pay less interest, make your payment before the due date. And like a mortgage you will pay less inter-est if you pay your credit card a couple of times a month instead of once.

Variable Rate Loan
In this case the loan interest is not fixed but floats depending on market conditions. Since interest rates can vary, either the term or the monthly payments are fixed, but both cannot be.

At the start of the loan a total borrowing cost is calculated the same way an installment loan is calculated based on the current interest rate. For individuals who want a fixed monthly payment but a variable term, the monthly payment is determined by a standard loan period. Each month the payment is taken and depending on the interest rate at the time a varying portion goes to pay the principal. If rates decrease, then the principal is paid off quicker than originally contracted. If rates increase during the loan period, then principal payments are decreased and you may need to make payments longer than originally anticipated. Often interest rates will increase and decrease over the course of the loan, it is a good idea to check in with your financial institution to see how your repayment schedule is shaping up.

If you want to keep the term fixed, then monthly payments would need to fluctuate when interest rates change. This type of arrangement is a little less common as people generally like to know what their payments will be.

In either case, making additional payments or increasing monthly payments will shorten the length of the loan and decrease the amount of interest you are paying.

To look at the effects of interest rates, monthly payments and term lengths take a look at our interest rate calculators by clicking here.