Interest & APR Explained – How Interest Works & How It’s Calculated

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Introduction

Interest is one of the most important financial concepts to understand — it affects your loans, credit cards, mortgages, savings, and even investments. Whether you’re borrowing money or earning it, knowing how interest and APR (Annual Percentage Rate) work can save you money, help you make smarter choices, and avoid costly mistakes.

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1. What Is Interest?

Definition:
Interest is the cost of borrowing money or the return on lending or investing money. It’s usually expressed as a percentage of the principal (the original amount borrowed or invested).

Two Perspectives:

• Borrower’s perspective: Interest is what you pay for the privilege of using someone else’s money.

• Lender’s perspective: Interest is what you earn for allowing someone else to use your money.

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2. Simple Interest vs. Compound Interest

1. Simple Interest:

• Calculated only on the original principal.

• Formula:

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• Example: Borrow $1,000 at 5% simple interest for 3 years → Interest = $150.

2. Compound Interest:

• Calculated on the principal and any interest already earned/owed.

• Formula:

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  where:
  P = Principal, r = annual interest rate, n = compounding periods per year, t = years.

• Example: Borrow $1,000 at 5% compounded annually for 3 years → Total = $1,157.63.

Why It Matters: Compound interest can work for you (savings/investments) or against you (credit card debt).

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3. What Is APR?

APR (Annual Percentage Rate):

• A broader measure of the cost of borrowing money.

• Includes the interest rate plus certain fees (e.g., origination fees, closing costs).

• Expressed as a yearly rate to make it easier to compare different loan offers.

Example:
Loan at 5% interest + $200 in fees might have an APR of 5.5%.

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4. Interest Rate vs. APR

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5. Fixed vs. Variable Interest Rates

• Fixed Rate: Stays the same over the loan term; predictable payments.

• Variable Rate: Can change with market conditions; payments may rise or fall.

• Tip: Variable rates can start lower but carry more risk.

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6. How Interest Is Calculated in Common Products

1. Credit Cards:

• Usually use daily compounding.

• Interest applies only if you carry a balance beyond the grace period.

2. Mortgages:

• Often calculated monthly.

• Amortization schedules show how each payment splits between principal and interest.

3. Personal & Auto Loans:

• May use simple interest, paid monthly.

4. Savings & Investments:

• Compound interest benefits you.

• Higher compounding frequency = faster growth.

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7. Daily Periodic Rate (DPR)

Credit cards often break the APR into a Daily Periodic Rate:

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Example: APR 18% → DPR = 0.0493% per day.

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8. Factors That Affect Your Interest Rate

• Credit Score: Higher scores = lower rates.

• Loan Type: Secured loans (e.g., mortgages) often have lower rates than unsecured loans.

• Market Conditions: Rates change with the economy.

• Loan Term: Shorter terms often have lower rates.

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9. How to Reduce the Interest You Pay

1. Improve your credit score.

2. Shop around for the best APR.

3. Make extra payments toward principal.

4. Refinance when rates drop.

5. Avoid carrying credit card balances.

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10. How to Make Interest Work for You

• Open high-yield savings accounts.

• Invest in dividend-paying stocks or bonds.

• Start early to maximize the power of compounding.

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11. Common Misconceptions

• APR and interest rate are the same → False.

• Paying the minimum payment on credit cards is fine → Dangerous.

• Compounding only matters for big sums → False — small amounts grow significantly over time.

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12. Key Takeaways

• Interest is the cost of money; APR is the full annual cost.

• Understand whether interest is simple or compound.

• Compare APRs, not just rates, when shopping for loans.

• Use compounding to grow your wealth and avoid letting it grow your debt.

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Final Words

That was confusing, wasn't it? Exactly! It's meant to be confusing and something that we as people don't understand. That's why we are continuously dealing with credit card debt and we can't get out from underneath it. It's important to understand that the banks and creditors make it this way to ensure they profit as much as possible off of you. Don't become the person that makes your minimum payments for decades, only to realize you still have $20,000 of credit card debt. That's the cycle you have to break!

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Let's see how we can help you change that. Get Started Now and we can show you what you can save to change your fortunes!