Credit smart: understanding – and using – different types of interest
Credit is a convenient and powerful tool to build assets or finance the things you need in life. It also inevitably comes with interest. Like all tools, credit interest should be used responsibly. That number sitting next to the percentage sign in the fine print plays a big role in your debt and credit score, so we unpack the different types that borrowers should know.
Fixed interest
This rate of interest is fixed throughout the loan repayment period and is agreed upfront between the lender and the borrower. This makes things really simple and easy, with both parties knowing what to expect. Borrowers know exactly what they’re in for and can easily budget for future payments. The only negative of this rate of interest is that you could end up with a higher percentage than variable interest rates, making your loan or mortgage more expensive over time.
Variable interest
The complete opposite to a fixed interest rate, a variable interest rate fluctuates all the time. This type of interest is tied to what’s happening with the prime (base) rate of interest. When the prime lending rate goes down, borrowers win because what they pay in interest will also decrease.
Simple interest
This type of interest is also known as flat rate or non-compounding interest. Simple interest is when the interest cost is calculated on the original amount of a loan over a particular period of time, which doesn’t change during the term of the loan.
Compound interest
Compound interest is like magic dust for investments ¬– that’s why Einstein called it the 8th wonder of the world. It’s interest you earn on the money you start with, boosted by all the interest earned on the interest that has accumulated over time.
For a lender, unfortunately, the reverse is true. The more you owe, the more you will owe over time. That’s because, every day of the month, interest is compounded on interest. The moment you make a purchase, that interest starts accruing. The best way to reduce your credit card’s interest rate is by:
- Making more than the minimum payment each month
- Paying your bill in full, if possible
- Making more than one payment a month to reduce your average daily balance.
Deferred interest
The word ‘deferred’ means delayed, so it’s when you’re allowed to temporarily pay less or no interest. This is great if you can pay the loan back in good time. But if you don't pay off the balance or make lots of late payments, you could be charged all the accrued interest from when you first made the purchase. Don’t be tempted by this type of loan agreement if you’re not able to make the payments each month, as it could end up more expensive in the long run.