Our Challenge: Understand How Interest Works

My challenge: explain interest so simply that anybody can understand it—and use it to make better decisions with their money.

• Music teacher. Student. Artist. Business owner. Engineer. Realtor.
• You shouldn’t need an MBA to understand how your money works.

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It all comes down to interest. While there is no historical proof he actually said this, Albert Einstein is widely attributed to saying:

Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t, pays it.

Did you earn interest last month? Or did you pay it?

Let’s look at some simple financial scenarios and learn a little bit more about how interest works.

Scenario 1. Cash purchase. In the first scenario, you decide to buy a house for $250,000. You pay cash for the house.

• Purchase price: $250,000
• Payment: Cash
• Interest paid: $0.00

Scenario 2. Simple interest. In this case, you decide to buy a house for $250,000. You don’t have $250,000, but you will have $250,000 in 1 year. The bank says it will lend you $250,000, but it will charge you 6.5% interest calculated each year. You agree to repay the full loan in 1 year. And you agree to pay the bank 6.5%.

• Loan amount: $250,000
• Interest rate (annual): 6.5%
• Term: 1 year
• Payments: 1 payment
• Interest paid: $16,250
• Loan paid: $250,000
• Total Payments: $266,250 ($250,000 loan + $16,250 interest)

Scenario 3. Interest over time. You decide to purchase a house for $250,000. You don’t have $250,000, but you will have $250,000 in 10 years. The bank says it will lend you $250,000, but will charge you 6.5%, annually. You agree to pay the bank 6.5% interest each year for 10 years, and in year 10, you agree to repay the full loan amount. (Interest only loan with a balloon payment due in 10 years.)

• Loan amount: $250,000
• Interest rate (annual): 6.5%
• Term: 10 years
• Payments: 10 interest payments, 1 balloon payment
• Interest paid:
  • Year 1: $16,250
  • Year 2: $16,250
  • Year 3: $16,250
  • Year 4: $16,250
  • Year 5: $16,250
  • Year 6: $16,250
  • Year 7: $16,250
  • Year 8: $16,250
  • Year 9: $16,250
  • Year 10: $16,250
• Total interest paid: $162,500¹
• Loan paid:$250,000
• Total payments: $412,500

This illustrates a simple principle we see in mortgages: the longer we borrow, the more interest we pay.

The real world is more complex than these 3 scenarios. But just because the world is more complex doesn’t mean that interest becomes more complex. Interest follows basic mathematical laws, and when you understand those laws, you can make more informed decisions.

Scenario 4. 30-year amortized mortgage: You decide to purchase a house for $250,000. You don’t have $250,000, but you have a job and can afford to make small monthly payments. The bank says it will lend you $250,000 at 6.5% interest, with equal monthly payments amortized over 30 years.

• Loan amount: $250,000
• Interest rate (annual): 6.5%
• Term: 30 years
• Payments: 360 payments (12 per month, 30 years)
• Interest paid: $318,861
• Loan paid: $250,000
• Total Payments: $568,861

A picture is worth a thousand words, so let’s look at how mortgage interest works.

As you can see, each mortgage payment is made up of Principal + Interest. This mortgage is for 30 years. There are 360 payments scheduled for this mortgage (30 years * 12 months). Let’s specifically look at how interest works in this mortgage. Following are some key elements of this mortgage:

Interest Rate:
The interest rate on this mortgage is 6.5%.

Interest Portion:
This is the percentage of each payment that goes toward interest. And as you can see from this graph, if you follow the payment schedule, you will pay more toward interest than principal for over 20 years of this mortgage.

Let’s look at another perspective of this same mortgage.

This graph shows the percentage of interest in each payment for 30 years. As you can see, you would pay over 85% interest in your first mortgage payments. In fact, you would pay over 80% interest for every payment for the first 5 years.

So there you have it.

Who would be crazy enough to pay more interest on a house than the house itself?

Apparently, most of us.

That’s how interest works.

And once you understand how interest works, you can start making better decisions with your money.

Now you’re ready to see how 1 = 5.