Types of Interest

Living a debt-free life may seem like a pipe dream.  But when bills are constantly hanging over your head and the only way to come up for air is to file for bankruptcy, there is one financial solution that may help save you--cutting the cost of interest.

Interest is the fee we have to pay on borrowed assets over a period of time.  There are many different types of interest.  There is good interest earned over savings and there is the percentage of the principal that is paid as a fee (the interest from borrowing money over time) called the interest rate.  In life, there are two main types of interest to worry about--interest that you owe to someone else and interest that someone else owes you.

Simple Interest

One of the most basic types of interest, simple interest is the easiest to understand.  The formula for simple interest is I = Prt.  Other types of interest rates are based on the same equation but can be a little more complicated.

Savings Account

Interest earned from having a savings account is one of the most common types of interest.  It is calculated monthly by using the annual percentage yield, or APY.  You earn APY every year but it's different from simple interest because it takes compounding into consideration.  If your bank offers 5% per year interest on your savings account but compounds your interest monthly, you will earn a little more than 5% on your money throughout the year.  The more often the interest compounds, the more interest you earn every year.

Compound Interest

Compound interest is also used by creditors to determine how much you will pay on money that you have borrowed.  Your interest on credit cards is compounded daily.  This is how credit card companies make their money.  The more often they compound the interest, the more money they earn. Credit card companies calculate interest by using an average daily balance.  This can further increase your interest rate.  This only applies to cardholders who carry a balance every month.  If you pay your bill off every month, you may never have to worry about being charged interest. One of the reasons credit card debt happens is due to high interest rates in excess of 13-20% or more depending on your credit score history. 

As long a you continue to carry a monthly balance on a credit card, the more interest you will accrue. The key to lessening your credit card debt is to find financial institutions offering low interest rates when you transfer balances on to new credit cards.  This can happen when you receive a promotional offer from a credit card company offering a 0% lifetime balance transfer.

The only catch to some of these promotional offers is usually to make a purchase or a cash advance before one of your billing cycles.  Occasionally, you can find a credit card company with one of these promotional 0% offers just requiring for you to transfer your higher balance credit cards to theirs.  With so many credit card scams out there, it's important to read the fine print.  There are some card companies out there only offering low interest rates over the course of a year and once the year is up, most cardholders will receive a letter of change in terms unless they have paid off the balance transferred.

Fixed Interest

When interest is at a fixed rate it means that it will not change for the life of the loan.  This type of interest rate is one of the best types of interest rates to have in the financial lending world.  Fixed interest rates are commonly found in loans associated with homes, vehicles, mortgages and occasionally with credit card companies.  One of the luxuries of having a fixed interest rate is because you will always know what your debt will be month to month.  Unfortunately, there are some disadvantages to accepting fixed interest rates.  If you happen to come across a better interest rate, and you have already accepted a fixed one, you cannot opt out of it.  This situation can hurt if the better rate is significantly lower than your current fixed rate.  Another disadvantage is when you sign up for a fixed rate during a promotional offer that isn't for the life of the loan.  This means once the promotional period ends, you are stuck with debt that will jump to a higher interest rate that is usually variable.

Variable Interest

Variable interest is essentially the opposite of fixed.  With variable interest, interest rates can change over time and are calculated on a reference rate by London Interbank Offered Rate (LIBOR).  The advantage of having a variable interest rate is being able to take advantage of interest rates when they drop.  When variable interest rates drop, you should try to pay off your loan, because when they skyrocket, you may wish you had.  Variable interest rates should be applied to small and manageable debt. 

Nominal and Real Interest

There are so many different types of interest but there are two that deal primarily with variables in economics more so than interest rates.  The term nominal interest, does not account for inflation.  Nominal is the rate that money is compounded and real interest is just the opposite.  With real interest, inflation has already been accounted for.  

Real interest is the actual value a person gets back.  If real interest rates are higher than nominal, you increase your chances of losing when it comes to investing or lending.  In other words, when you borrow, it is better to have negative real interest rates because the real value of money you use to pay your debt is lower than the value of the money you borrowed.

Whether you borrow, lend or save, the lower your interest rates, the better chance you will have of increasing your earnings.  Lower interest rates help to stimulate the economy, business investments and long term financial security.  When it comes to deciding on the best types of interest for you, the answer is simple: as low as you can go.