#24: Interest: Why am I paying so much in interest?

In this episode, we are going to walk you through what interest is and how (more importantly) it impacts you. 

We discuss:

• Simple Interest
• Compound Interest
• Variable Interest
• Fixed Interest

and what the Annual Interest Rate (APR) is.

Interest can cost us thousands of dollars, and is very sneaky. It is not advertised in lights or BOLD print. It is buried in the fine print because if you knew how much you would be paying, that would be the biggest deterrent for the purchase!

Listen in on this lesson. I hope it will save you thousands of dollars!

Links mentioned:
https://www.calculator.net/credit-card-calculator.html

https://myratecompass.ca/credit-cards/

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Transcript

#24: Interest: What you need to know

[00:00:00] If you're anything like I was staying on top of your budget is not an easy task. Paycheck to paycheck would go by and you're no further ahead. For my listeners, I am giving you this free guide that is going to take you to the next level. It's got 10 easy tips to follow. To help you stay on track with your budget, just head to the financial moment.com/budget dash.

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Hello everyone. My name is Carolyn. Welcome to the saving for your first home podcast. I am the CEO of the financial moment. We offer money coaching for those who are ready and willing to make financial changes in their lives. For the most of us, there comes a point in time where we think to ourselves, it will be really nice to own property, but it sometimes can feel like a pipe dream, and not very easily obtainable. [00:01:00] So I created this podcast to give you all the information and tools you need to take the steps forward toward home ownership. Take it from me, my husband and I started our lives together, working part-time jobs with a young child, fast forward through many hiccups and failures. We stepped our feet into our very first home. 

For us it was a pile of dirt, but eventually our family home was built on that dirt. Now we are in the midst of growing our investment property portfolio. I created the savings for your first home podcast to give you easy, actionable tools for you to do the same. If you have that same gut feeling that I did and want to create a life for yourself and your growing family, but don't know where to start.

You are in the right place. Let's do this. 

Hello everyone. Thanks for joining this episode of Saving for Your First Home. Today I'd like to talk about the topic of interest and that word, you know, [00:02:00] it tends to bring us joy. And it also brings us pain, probably more pain than joy, to be honest with you, , and there are so many different kinds. So we have simple interests, we have compound interests, we have variable interest, we have fixed interest.

There's the annual interest rate. But what do all these mean? And more importantly, how do they affect us? Interest is a sneaky fee. It's not advertised in lights or in bold print. It's often buried in the fine print because if you knew upfront how much extra you would have to pay for an item, you'd be out there, you'd be running so fast.

The other direction and my experience with interest hasn't really been a fun one. Between credit card interests, interest online of credit, mortgage interest, I must have spent hundreds and thousands of dollars. Could that have been avoided? Perhaps more like absolutely . [00:03:00] So let's walk through the various types of interests and how it can impact you.

So let's start. Simple interest. And as the name states, it's a simple formula. Simple interest is calculated by multiplying the loan principle by the interest rate, and then you multiply that by the term of the loan. So for instance, if you have a $10,000 loan and the interest rate is 5%, and the term of the loan is five years, you would multiply 10000 times 5% or 0.05, and that would give you $500. Then you would take that $500 and multiply it by the term of the loan, which is five years. So what we know after we do this calculation is that the interest is going to come to $2,500. Therefore, the cost of borrowing is $2,500, otherwise known as [00:04:00] interest.

So that $10,000 loan that you got now has cost you $12,500. And the common places where you'll see simple interest used is in personal loans or automobile loans, or your basic savings account. However, in the case of a savings account, the rate is much lower as there's really no risk involved in that investment.

 Next up we have compound interest. Now, Albert Einstein once said, compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't pays it. And to be honest with you, that statement couldn't be more true. So compound interest is the interest on savings or a loan that is calculated on both the initial principle and the accumulated interest from previous periods.

Okay. So in simpler terms, it is [00:05:00] interest upon interest, . It will make a sum grow faster than simple interest, which is calculated basically only on the principle amount. So let's go back to our original example. We borrowed $10,000 and the interest rate is 5% for five years, right? , but in year one, we paid $500 towards interest, right?

We multiplied 10,000 times 5% and we got $500. Now, this is the same principle when you're calculating compound interest, but in years two to five, this is where it changes. In year two, you would take 10,500 and multiply that by 5% to get $525. So in year two, it costs you 5 25. In year three, you would multiply $11,025 by 5% and it'll come to $551. [00:06:00] 25.

right? So you can see how it's slowly building, right? In year four, the interest would be $578 and 81 cents, and in the fifth year, the interest would be $607 and 75 cents. So if you notice there is a pattern, it's going up every year because you're being charged interest on the interest. , right? So in total, that $10,000 loan over five years now cost me $2,762 and 81 cents, as opposed to the $2,500 if we were just using the simple interest calculation, right?

So that's quite a bit different. Now you need to be careful because some institutions will use compound interest, but it will compound. Monthly or even daily. The more it compounds, the more [00:07:00] interest you end up paying. So a good example of this is the good old credit card. Now, generally, they compound the interest daily if you haven't paid off the balance by the due date.

So let's say you purchased that cute top on your credit card for $40. If you don't pay that card off by the due date, the credit card company will charge you interest daily until the amount is paid. Now there are some great calculators out there that will calculate the exact amount of interest and the amount of time it will take to pay off the amount if the minimum payment is only paid.

Also, if your credit card shopping, there is a great website that will compare each card based on your habits. So I'm gonna give you those links in the show notes of this episode. The next thing we should look at is a variable rate. Now, this is used predominantly in mortgages, but there are also a few credit cards out there as well that offer [00:08:00] variable rates.

But before we can talk about variable rates, we need to understand what the prime rate is. The prime rate, also known as the prime lending rate, is the annual interest rate Canada or the United States or any other country. Were there. Major banks and financial institutions used to set interest rates for variable loans, lines of credit, variable rate mortgages, and in Canada, the Bank of Canada sets the prime rate and the banks will use that as the basis to set their own specific rates.

So a little history about us. When we bought our first home, we were so nervous about the thought of going into a variable mortgage. It was frightening. We totally wanted stability with no risk of the rate changing for a period of time. But, you know, as the years passed, we became more confident and we wanted to take advantage of the low interest rates that the banks were offering with a variable mortgage.

[00:09:00] Which would mean that we'd be placing more of our heart earned money to the principle of the mortgage and less to interest. So choosing an interest vehicle when buying a home is a very personal choice. There are advantages and disadvantages to both as well. The risk is different for either method. and now the banks have all sorts of products that will allow you to split a mortgage, make it into a revolving credit, and so much more.

So keep listening to the podcast because we are going to have experts to come visit us and help with these types of decisions. Okay. Sorry. Back to the variable rates. The rate of the loan is dependent on prime. So for instance, a variable mortgage rate could be prime plus one. This would mean that your rate is whatever prime is at the time, plus 1%.

And on this day of this recording, it was 6.45 in Canada. Therefore, if I had a variable rate and it was prime plus one, [00:10:00] my rate would be 7.45%. And this is calculated the same way compound interest is calculated, but it will change whenever prime changes. . So we're in very interesting times right now because not even a year or so ago, maybe two years the interest rates were incredibly low, and so a lot of people jumped into a variable interest rate.

But now, as prime is slowly creeping up, they're being negatively impacted by these rising prime rates, and they're paying more interest on their mortgage than a year or two ago. . So let's look at what a fixed rate is. This is the rates established by a lending institution. The rate doesn't change over the course of the term like we saw in the variable rate, and sometimes we'll see fixed rates.

 When you borrow. [00:11:00] For an automobile or a personal loan, and definitely with a mortgage, the rate is set at the beginning and it remains constant throughout the term. Now, in the case of a mortgage, a fixed amount of time is also set. Banks will turn this as being locked in. If a mortgage is not paid at the end of the term, then the client will need to negotiate a new rate based on what is currently being offered.

So just to give it to you in, in practical terms, if you locked in an interest rate of let's say 3% two years ago, you won't find anything like that now and you locked it in for five years. So you would be honored that 3% rate, regardless of what is happening with the prime rate. So for five years you'll be paying your 3%, but.

After that five year period is over, you need renegotiate with the bank, and at that time it could be much higher, which is what is [00:12:00] happening right now. Like I said, prime is 6.45, so the fixed rates could be hovering around five to 7%, depending. So this is where the debate comes in. What will cost you more a variable mortgage or a fixed mortgage?

Really, nobody can protect this. Fixed rates are generally higher than variable, but variable has the potential to increase. So this is why it's entirely a personal choice based on your own risk tolerance. 

Next up we need to look at the term annual interest rate apr. You'll see this very frequently on a credit card or a loan.

They'll quote what the APR is and you'll think that that's the interest rate that you're going to be paying. Now again, you can't think in simple terms because majority of the time they are compounding. These rates and in the example of a credit card, they are compounding it [00:13:00] daily. So you remember our example of 10,000 at 5%.

Well, that was $500, but the next month it was 5 25. So imagine if they were compounding that daily. So the a APR that they're quoting is really not the true apr. They'll have the amount of, you know, a typical credit card would be 23%, 22 point something percent. And then we'll have another number beside it, which is a very small number.

It'll be like, I don't know, 0.00674%, and that's what they say is your daily interest rate. Well, again, you can't use it in simple terms. You must compound it. So that $10,000 every day, incurrs some interest and then we take that interest and we put interest on that interest and we keep going from there.

So the APR is kind of deceiving, so I wanna make sure that you guys use the calculators, find [00:14:00] out how much it is that you are going to end up paying an interest, and that is why I encourage you to pay off debt as soon as possible so that you can avoid yourself from incurring more money owed than you really need.

Now, I briefly touched on balance transfers, and it's an important thing I wanna touch upon because it's a way to kind of get. A handle on the debt. So if you are on a mission to clear any credit card debt, there are offerings out there where you can transfer a balance from one card to another for perhaps a fee, and they will say, okay, we won't charge you any interest for six months, or they'll charge you a very nominal amount for a period of time. . Now, the only way to use this as a tool to actually help you is if you are not going to get further into debt. [00:15:00] So if you're going to transfer a balance from one card to another, I do a balance transfer, then cut up the card. Because it is too tempting to move that balance off of that card onto another vehicle, and then all of a sudden your credit opens up and you are able to spend more money and take it from me.

Like I have learned these lessons over the years, so I want you guys to understand that. The card needs to be cut up because if you've rent over the month and you aren't able to pay the balance off, it means that you're not on top of your spending, and that's not gonna change. By transferring a balance onto another card, your habits haven't changed.

The only thing that's changed is the balance on the card, so we really need to kind of address what the habits are, take a hold of how you're spending money, and really try and curb the behavior. In order not to run up more debt. [00:16:00] So again, it's a great mechanism if you can use it to your advantage and not run yourself into more debt.

And there you have it. That is interest in a nutshell. But my advice is to do your research before entering into any type of loan, credit card line of credit mortgage.

Understand exactly how interest is being calculated, and then take the steps to avoid incurring interest as much as possible. . So for example, if you're looking at getting a credit card, check out the websites that I linked in the show notes because it can compare based on your own spending habits. If you know that you tend to overspend and carry a balance, then there are cards that have lower interest rates and that would cater to those types of spending patterns.

if you know that you pay off your card every month, then there are credit cards that are catering to you, giving you points and advantages to doing that. So you really need to do as [00:17:00] much research as possible, take advantage of the grace period, right? For credit cards, it's usually 21 days. Take advantage of 0% offerings and balance transfers if you need.

Interest eats away at your income and it prevents you from using the money the way you want to. So be aware and be diligent, and I really hope this lesson will save you a couple of thousand of dollars. 

Thank you for listening. We are committed to helping you place your very first steps into your new home. See you next time.