Markie writes in:
My biggest struggle with personal finance is the numbers. I am terrible at math. When I look at percentages and stuff, I just want to lock down and tune out.
This is actually a pretty common thing. One of the brightest people I know – an amazing writer who is a creator of endless good ideas – struggles with the math needed to balance her checkbook. She has endless skills in many areas of life, but math just stumps her.
While I can’t possibly address every math question, I do regularly hear about percentages and interest rates from readers. So, here’s a basic explanation of how percentages and interest rates work.
Let’s say you see a credit card offer with a 19.9% interest rate. What does that actually mean in terms of dollars and cents?
The easiest way to understand percentages is to think about them in terms of $100. 19.9% of $100 is simply $19.90. 30% of $100 is $30. That’s easy enough, right? If you just think of things in terms of $100, it works out really well.
So, what do you do if the amount is more than $100 or less than $100? Well, you know that 19.9% of $100 is $19.90, right? If you want to know what the interest is on $5,000, for example, you just divide $5,000 by $100, giving you 50. Then, multiply that number by $19.90 and you’ll get your answer – $995. If you owe $5,000 at 19.9% interest, it will cost you $995 over the first year in interest.
(Note that this is an approximation of what you would owe over the course of a year. In reality, interest is almost always calculated more frequently than once a year, which means that a single calculation just approximates what you’ll actually owe. For example, a company might calculate 1/12th of your annual interest each month. This earns them a little bit more money.)
That’s how you figure out how much interest you’ll earn in a year. On a credit card or any other debt, that interest works against/em> you – it means you’re going to have to pay that much more if you don’t pay off that debt at all over the course of a year. If it’s money in your savings account or in an investment, it works for you – that’s how much you’ll earn over the course of a year.
What if you want to figure it out over multiple years? First, just figure it out for one year. For example, above, we saw that if you have $5,000 at 19.9% interest, you’re going to earn $995 over the course of a year. What about the next year?
Well, in that case, you add the $995 to the original $5,000 and you’ll have the balance after the first year. You now have $5,995 at 19.9% interest. So, you whip out your calculator and divide $5,995 by $100, giving you 59.95. Then, multiply that number by $19.90 again, giving you $1,193.005. Drop off the extra number, so you’ll just have $1,193. Now, add that to $5,995 and you have the amount you’ll owe after two years – $7,188. You can keep doing this over and over and over again for as many years as you want.
You just keep repeating this for each year. What you’ll notice is that interest causes money to grow faster and faster over time. Again, this works against you if you owe someone money, but it works for you big time if you’re looking at your own money.
In my experience, the real key to understanding interest rates is to think about them in terms of $100. If you start there, it’s much easier to work things out from that point.