
If ever there was a poster child for love-hate relationships, it’s got to be interest. It makes savers grin from ear to ear, but borrowers feel like they just got sucker punched. The dark side of interest is that it’s the cost of borrowing money, and it mounts up the longer you wait to repay.
Interest is the fee you pay for borrowing money, calculated as a percentage of the amount you owe.
I’m about to illuminate this beast’s gloomy side, explaining how interest works so you know what you’re facing when you deal with loans and credit cards.
The Basics of Interest
If you’re borrowing money, you better know what you’re signing up for. Understanding the types of interest and how they work in loans and credit cards is just plain smart.
Simple Interest
Simple interest usually shows up in short-term loans.

It’s cheaper than compound interest, since you pay interest only on the amount that you originally borrowed and not on any interest that piles up over time.
If what you want is to keep costs low and predictable, then simple interest is the way to go. It won’t gang up on you as relentlessly as compound interest does.
Compound Interest
Compound interest is applied to items like mortgages, credit cards, and long-term investments. It costs more than simple interest, more so the more frequently it is compounded.

This is because, under compound interest, you are paying interest on both the principal and any interest that is added.
It grows at a speedier rate as the compounding period decreases from monthly to weekly to daily to continuous. The more frequently it compounds, the more money you will have to shell out.
How to Calculate Interest
You can calculate interest on a spreadsheet or a calculator. But if you have a hankering to get down into the weeds, this next section should tickle your fancy.
Simple Interest Formula:
I = P × r × t
A = P + I
Where:
- I is the amount of interest
- A is the amount of money after interest
- P is the principal (amount borrowed)
- r is the interest rate (expressed as a decimal)
- t is the time period (in years)
Example: Let’s say you borrow $1,000 at 5% simple interest for one year. You can plug the numbers into the formula:
I = $1000 × 0.05 × 1 = $50
A = P + I = $1000 + $50 = $1,050
So, you owe $50 in interest at the end of the year. It’s as simple as that.
Compound Interest Formula:
This formula is a bit more complicated:
A = P × (1 + r / n)n×t
I = A – P
Example: Now, let’s say that same $1,000 is compounded daily at 5%. That’s 365 compounding periods in a year, so here’s how the formula shakes out:
A = $1,000 × (1 +0.05 / 365)365 × 1 = $1051.27
I = A – P = $1.051.27 – $1,000 = $51.27
So, after one year of daily compounding, you owe $51.27 in interest. See how it’s $1.27 more than the $50 from simple interest? That’s because you’re paying interest on interest every single day.
The effect doesn’t seem all that impressive, but imagine a $10 million loan instead of $1,000 — compounding is nothing to sneeze at.
How Credit Card Interest Works
If you’ve ever found yourself scratching your head about your credit card bill, it’s probably because of that pesky interest. The number will be a puzzle if you don’t know how credit card interest works.
You can gain clarity by understanding how interest applies to your unpaid balance. Know this well: If you don’t pay the full bill each month, interest will hit you quickly.
APR and Credit Card Interest Rates
APR (Annual Percentage Rate) is the interest rate the credit card companies throw at you in their ads, but what does it really mean? The APR is an annual interest rate on your balance, but it isn’t exactly the true cost of credit. It does approximate how much it would cost in interest in a year if no payments were made; it just doesn’t give all the details. It’s like a witness who holds back key information.

Now, here’s where it gets a little sneaky. While APRs are calculated using simple interest for the whole year, most credit cards compound interest daily. In addition, APRs don’t include all those fees credit cards love to throw at you. So, while the APR might just seem manageable, your total cost can rack up rather quickly.
Credit card companies largely base their interest rates on your credit score and bill-paying history. Issuers use this information to judge how risky a borrower you are. Within a set range, the higher your score, the lower your rate; the lower your score, the higher your rate. Typically, credit cards sport APRs from 15% to 36%.
How You Accrue Credit Card Interest
Okay, all is well and good, but how does this whole interest business work? Well, if you haven’t paid off your entire balance by the due date, then the credit card company begins charging you interest on what you owe.
Most credit card companies use the Average Daily Balance (ADB) method to figure out how much interest you owe. This means they add up your balance for each day of the billing cycle and then divide that total by the number of days in that cycle to determine your ADB.
Once they compute your ADB, they apply the Daily Periodic Rate (DPR), which is your APR divided by the 365. If you’re dying to know how this works, here’s the nitty-gritty:
Average Daily Balance (ADB) Formula:
ADB = ∑(Daily Balances) / Number of Days in the Billing Cycle
Daily Periodic Rate (DPR) Formula:
DPR =APR / 365
Interest Formula:
Interest = ADB × DPR
Let’s break it down with an example.
Step 1: Calculate the Average Daily Balance
Let’s say your APR is 18%, and over a 30-day billing cycle, your daily unpaid balances carried over from the previous cycle fluctuate like this:
- Days 1-10: $1,000
- Days 11-20: $500
- Days 21-30: $750
First, you calculate your ADB:
ADB = (($1,000 × 10 days) + ($500 × 10 days) + ($750 ×10 days)) / 30 days in billing cycle
ADB = $22,500 / 30 = $750
So, your Average Daily Balance is $750.
Step 2: Calculate Daily Periodic Rate
Next, you compute the DPR:
DPR = 18% / 365 = 0.049315 = 0.00049315
Step 3: Calculate Interest
Now, calculate the interest for the whole 30-day period by multiplying ADB with DPR:
Interest = $750 × 0.00049315/day × 30 days = $11.10
So, after 30 days, you’ll owe about $11.10 in interest on your credit card balance.
Now, what can help you dodge this interest trap? It starts with a little thing called the grace period. Most credit cards give you a grace period of about 21 to 25 days from the end of your billing cycle to pay your balance in full without any interest.
It’s like a free get-out-of-jail card: Use it right, and you will not owe one penny in interest on your purchases.
However, suppose you fail to repay the full bill during the grace period. In that case, interest begins to run up quickly. The interest compounds daily and continues to pummel you until you pay the balance.
What’s more, any new purchases trigger immediate interest until you get even. That’s why paying off your balance before the grace period expires avoids a real hornet’s nest of trouble.
Strategies to Minimize Credit Card Interest
You need to outsmart the system if you want to avoid a high-interest charge at the end of the billing cycle. A fantastic trick that could help is debt consolidation, where you repay your debts by taking out a loan, hopefully with a low interest rate. You then repay the loan in fixed monthly installments. Try not to create any new unpaid balances until you polish off the loan.
Alternatively, many cards offer new card members a promotional balance transfer. These cards have a temporary 0% APR for a set period after account opening. You can transfer your unpaid balances to the transfer card and avoid interest (although the issuer will charge a transaction fee of 3% to 5% per transfer). You’ll be sitting pretty if you pay off the balance before the promotion ends.
Here’s another neat trick: Make several payments a month if you can. The less you owe, the less interest they can slap on it.

Ideally, you’d like to avoid interest entirely. I suggest you manage that credit card debt with a good, old-fashioned budget. You have to know where the money is going if you are ever going to wrestle interest to the ground.
Figure out what you can pay off each month and stick to that number. It may not be easy, but keeping yourself in check is what keeps you ahead.
Another smart move is using your debit card more than your credit card. You can’t go into debt if you spend your own money, and there isn’t any interest to worry about. Save the credit card for things you know you can pay off when the bill comes due, and keep that plastic from burning a hole in your wallet.
And finally, feel free to call up the credit card company and ask for a lower interest rate. You won’t believe it, but they’d rather give you a break than have to hassle with you not making your payments.
How Loan Interest Works
Now, when you are borrowing money for something big, like a car or a home, it’s important to know how loan interest works. Otherwise, you’ll find yourself paying way more than you bargained for.
Whether from personal loans, vehicle loans, or mortgages, that interest can add up fast. So, get the whole picture before you sign on the dotted line.
Fixed vs. Variable Interest Rates
With loans, you usually have two interest options: fixed or variable rates.
- Fixed interest rate: A fixed interest rate is set and continues for the life of the loan. No matter how much the economy rides a rollercoaster, your rate won’t change, which makes it easier to plan your payments.
- Variable interest rate: On the other hand, a variable rate can change over time, depending on the credit market. You may be flying high with low payments one month and just hanging on for dear life the next as rates shoot up. Variable rates are typically lower than fixed ones at the get-go, but you never know when they might spike.
The pros and cons of each type of rate come down to risk and stability. Fixed rates are fabulous if you want predictability, especially if you lock in a rate at a time when interest rates are low.
You can set your budget and know exactly what you will owe each month, which in turn can make it easier to rest at night. Plus, if the economy does take a nosedive and rates rise, you’re sitting pretty with fixed rates locked in.
However, variable rates have their own special charm, especially when prevailing rates are low and remain that way for a long time. You may be able to start out with smaller payments than you’d get with a fixed rate, meaning more jingle in your pocket early on.
Here’s the catch, though: variable rates can cause those payments to leap upward at any moment. It’s a dicey proposition, and often, you will end up paying more than you anticipated.
Amortization and Loan Repayment
Now, let’s deal with amortization, or how you repay your loan over time. The interesting thing is that when you take out a loan, the payments go to pay off both interest and principal. In other words, early on, most of your money goes to paying off interest while just a small piece chips away at the principal.
It’s like a snowball rolling down a hill — it’s slow at first but gains momentum over time.
You’ll make the same payment each month, but as time goes on, more and more of your money goes toward paying off the principal. By the time you’re near the end of the loan, you actually are paying next to no interest. It’s kind of slow, but it’s steady, and you can hang your hat on the monthly cost.
In the first years of a long loan, you might feel you are treading water, scarcely making a dent in how much you owe. But stick with it, and one day you will have paid that debt off one shovel full at a time. That’s the magic of amortization working in your favor.
Prepayment Impact on Interest
Now, if ever you find yourself with some extra money on hand, you may want to consider early payments on your loan, and that’s when the fun begins. All prepayment ultimately means is just tossing a little more money onto your loan to pay it down faster, which in turn can save you quite a lot of interest in the long run.

However, some lenders frown upon people who pay a little too early. They charge a prepayment penalty — a fee to make up for the lost interest. It’s like renting out a cabin and leaving early. Just because you leave doesn’t mean you don’t owe for the full week.
So, before you start throwing extra cash at your loan, check to see what kind of penalties may be lurking in the fine print. Of course, it is usually a good thing if you can prepay without any penalty.
It might take some discipline, but it’ll be worth it in the long run.
Interest is the Added Cost of Using Loans and Credit
Interest is what you pay for the privilege of borrowing money, and it can rack up fast. Whether it is on a loan or credit card, pesky interest wants to gnaw on your wallet. The more you know, the better you can manage it and keep your finances from falling into a deep pit.