When you take on debt, you pay for the privilege of using money that doesn’t belong to you. Whatever you buy on credit will cost you the original price, plus interest. This article will show you how to calculate the interest you will pay before you take on debt.
Tip: Interest can work for you or against you. It’s one of Just One Lap’s five key concepts to make good financial choices.
First, the maths
Example: You want to buy a new Bluetooth speaker that costs R1,500 using in-store credit. The interest rate is 20.5% per year and you intend to pay it off over six months.
There are two amounts you have to keep track of here:
- Your principal amount: This is the amount of money you borrowed. To calculate your monthly repayment, divide the amount you borrowed by the number of months over which you’ll repay it, i.e.: R1,500/6 months = R250p/m
- The interest: The interest in our example is an annual rate, so let’s first calculate the monthly rate, i.e. 20.5%/12 months = 1.7%p/m
Next, we need to add the monthly interest rate to what you owe. As you learned in this post, you can calculate 1.7% of R1,500 by multiplying R1,500 by 0.017. That gives you R25.50 interest for your first month.
You can also add the interest to the principal amount like this: R1,500*1.017% = R1,525.50
To meet your target of repaying your speaker in six months, you repay your first R250 plus the R25.50 interest, i.e. R275.50.
In the second month, you don’t have to pay interest on the entire R1,500, because you’ve already paid back R250. Now you owe R1,250. The interest in your second month will be R21,25:
R1,250*0.017 = R21,25
Every month you need to subtract the amount you’ve repaid from the amount you borrowed to calculate the amount you need to pay interest on.
|Total interest paid||89.25|
|Total cost of the speaker||1500+89.25||1589.25|
To determine how much interest you paid over six months, simply add the interest rate payments together. This will give you a total cost of R1,589.25
You can also calculate the rate this way:
[Principal amount – (monthly repayment rate*number of months)]*monthly rate.
Always keep the following in mind
- Interest can be calculated daily, monthly or annually. It’s important to know when interest is calculated to determine the best approach towards your repayments. For example, interest on home loans is typically calculated daily, while interest on credit cards is calculated monthly. That means on a home loan, paying a few days earlier than the date required by your bank can make a difference in the interest you pay. This, however, doesn’t hold true for a credit card. With vehicle finance, the interest is sometimes calculated in advance and included in your monthly repayments.
- Interest compounds. Compounding is another financial concept that will save your bacon. We usually talk about compounding in positive terms, like when the interest you earned earns you more interest. Just like interest, however, compounding has a dark side. When you take on debt, the interest you pay compounds over time. If you miss a repayment, you pay interest on your minimum repayment as well as on the interest payment you missed the month before. This can quickly spiral out of control.
- Money-lending institutions benefit from longer repayment periods. You, on the other hand, don’t.
Interest can be negotiated. When you take on long-term debt like a home loan, you can request an interest reduction every year. Your request might not be successful, but you can definitely ask. For shorter-term debt, you might not be able to negotiate a lower interest rate. Still, if you are struggling to meet your repayment obligations, you can ask for an extension on the repayment period. This article explains more.
Many of us avoid making financial decisions because we worry that we can’t do the maths. Luckily, there are only a few formulas you need to understand to make a good financial choices. This series of articles is dedicated to helping you understand how to do the calculations for yourself. Once you grasp these simple formulas, you can make better financial choices on the fly.