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When 3 is More Than 4

Money and interest can work for you or it can work against you. Understanding how different kinds of interest work and knowing how to manage them makes a major difference in your lifetime financial success.

Question: When is a 3% interest rate greater than a 4% interest rate?

Answer: When 3% is compounding and 4% is amortizing!

You may be asking yourself, “How can that be true?” It is! In order to understand why, let’s have a brief introduction to what these terms mean and how interest is calculated using each method. Understanding interest and how it works for (or against) you is critical to making better financial decisions. This knowledge has a major impact on your financial success throughout your lifetime. Here are some short definitions and links to additional information from Investopedia, a site I find helpful for providing clients with simple explanations of complex financial terms.

AMORTIZING : Amortizing interest occurs when you are paying interest on a declining principal balance. This kind of interest is found in auto loans, home loans and (hopefully) student loans. With amortizing interest, you are making a payment that includes an amount to pay the interest for the month and an additional amount toward the remaining principal owed to the lender. Amortizing interest decreases with each payment, even though the rate stays the same. This is because the interest is paid on a smaller balance with each payment. Your payment typically remains the same but the amount which goes toward interest decreases each month and the amount applied to principal increases.

For example, if you owe a balance of $1,000 and the rate is 12% annually, the interest in the first month is $10. If you make a payment of $100, $10 will go to interest and $90 will go to principal. The next month, your balance would be $910. The interest that month would be $9.10. If you pay the $100 payment next month, $9.10 will go to interest and $90.90 would go to principal. Each month, less of your payment goes toward interest and more goes toward principal. As you continue making payments, your interest paid and principal balance amounts are reduced until you hit $0. Then, you borrow more money, right? WRONG!! Instead, you should save it and invest it into something which is compounding.

COMPOUNDING : Compounding interest occurs when you reinvest your interest (or earnings) and earn interest on your interest. If you continue this process, the interest accumulated in your investment can even exceed the value of your deposit. This is why Einstein is said to have called compound interest “the 8th Wonder of the World”! By compounding interest, you are earning interest on an ever-increasing amount of money, this is the opposite of amortizing interest. Normally compounding interest is experienced only by savers and investors, which is part of how ‘the rich get richer’. However, you must beware since it can occur on loans when payments are not being made toward the principal. Compound interest can be your best friend or your worst enemy. This is one financial force of nature that you want on your side!

Now, let’s look at an example of a $10,000 loan amortizing interest at 4% over 4 years compared with a $10,000 account compounding interest at 3% over 4 years:

Amortizing Loan Calculation
Initial loan amount $10,000.00 Monthly payment $225.79
Annual interest rate 4.00% Number of payments 48
Loan period in years 4 Interest Paid $837.95
Start date of loan 6/9/2016 Total cost of loan $10,837.95
Compounding Savings Calculation
Initial deposit amount $10,000.00 Monthly Deposit  $0.00
Annual interest rate 3.00% Number of payments 48
Term period in years 4 Interest Earned $1,273.28
Start date of deposits 6/9/2016 Total Value of Account $11,273.28

So what is the point of all these numbers?

The point is, making financial decisions regarding debt and savings is more complex than simply comparing rates. You can see that just comparing rates does not always provide the correct answer. Comparing rates is like going shopping and only comparing prices. This is what consumers do when then they don’t know anything about the product and they don’t know what else to ask or how else to compare different products.

Anyone who has ever purchased the cheapest items has probably learned, cheaper is not always better. There is more to cost than just price. Pricing a good or service is not as critical as getting the best value. What does it do, how long will it last, why should I pay more, will it save me time, money or energy? These are the questions that informed consumers, wise businesspeople and financially successful individuals ask themselves and the professionals they consult.

The question of what to do with money is not always as simple as withdrawing a 3% deposit to pay off a 4% loan. This makes perfect sense when you think about it but the math tells a different story. In the example above, the wrong answer would cost you almost $110 per year and that is on just $10,000 for 4 years. Imagine the cost of the wrong decision on a $250,000 home loan over 30 years! Comparing rates may cost you money, even when it sounds logical. The rate is not as important as the dollars and cents are.

More important questions are: what kind of interest are you comparing, is it compounding or amortizing, how much money is involved, what is the real financial cost? The best solution will change depending on your individual circumstances. There is not one correct answer to these questions, except DO THE MATH!

If you are like many of my customers and you don’t know how to figure this out (or you just don’t want to), don’t feel bad just speak with someone who does. Questions like these are why financial advisors like me have a job!