When you save money, you earn interest. When you borrow money, you pay interest. How much interest you earn or pay depends on how it's figured. Calculations are often based on daily interest rates, even when you are talking about a long-term contract like a mortgage loan.
Simple Interest, Daily Interest
Interest calculations start with a simple interest rate, which is a percentage of the principal amount of an investment or loan. Suppose you buy a $1,000 bond that pays 4 percent interest yearly. At the end of the year, the bond issuer sends you $40. That's simple interest. Typically, the interest paid on savings accounts or charged on money you borrow relies on a daily interest rate, also called a periodic rate with a one day period. Divide the annual simple rate by 365. For a 4 percent annual rate, this works out to about 0.011 percent.
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Daily Compound Interest
When savings account interest is calculated daily, it works to your advantage. Suppose you put $1,000 in an account with a 4 percent simple interest rate. The bank calculates interest daily and adds it to your account balance. Each day starts with a bit more money in your account that also earns interest. This is what the term "compound interest" means. At the end of the year, you find the total interest earned is about 4.08 percent instead of 4 percent. The same thing happens when you deposit more money in the account. The newly added funds start earning interest the very first day they are in your savings account.
Daily Interest and Borrowing
Lenders often use daily interest rates to calculate finance charges. Suppose you have a credit card with an 18.25 percent annual rate and a balance of $1,000. When you divide 0.1825 by 365 days, the daily rate works out to 0.0005. Credit card issuers usually apply interest calculations to your average daily balance. If the billing period is 30 days and you charge $50 after 15 days, your average daily balance increases to $1,025. Multiply $1,025 by the 0.0005 daily interest rate, which gives you $0.5125. Multiply $0.5125 by 30 days to calculate the finance charge for the billing period of $15.38.
Daily Rates and Installment Loans
Car loans and mortgages are examples of amortized debts. This means the loan repayment consists of a fixed number of equal payments. When you make the last payment, the debt is paid. Some lenders use a daily interest rate to calculate interest. Suppose the monthly payment on a car loan is $300, the balance is $10,000 and the annual interest rate is 10.95 percent. Divide the annual interest rate, or 0.1095, by 365 for a daily rate of 0.0003. Multiply the $10,000 balance by 0.0003 and you find the amount of interest per day equals $3. If the month or billing period is 30 days, multiply $3 per day times 30 days and you have a monthly interest charge of $90. The lender applies the remaining $210 of your payment to the balance, lowering it to $9,790. Next month, less interest accrues. With installment loans, although the daily interest rate doesn't change, the amount of interest steadily declines. By the time you get to the last few payments, very little interest is charged.