Interest is Calculated Daily, but paid Monthly

The concept of compound interest is not a normal nor interesting conversation piece, however it is interesting to note that compound interest is really important to all of us, even though most of us don’t understand it! Let’s change that; to become interested in interest.

WARNING: There is maths ahead… but please stay with me as, interestingly, it’s worth it!

Interest is money paid regularly at a particular rate for the use of money. Interest is charged by the bank for money that they lend to you and interest is paid by the bank to you for money you have deposited, ie savings. In simple terms, interest is calculated on the original amount of a loan or the original amount of funds deposited to an account.

Compound Interest is calculated on the original amount (of the loan or deposited savings) and also on the accumulated interest of the previous periods. It is also referred to as “interest on interest”.

Let me explain/explore what this means to you…

WHAT COMPOUND INTEREST MEANS TO YOU AS AN EXISTING HOME OWNER… for your home loan, the bank calculates the interest charged on a daily basis and charges it monthly. For example, at day one, your original loan amount is say $500,000 and each day the bank calculates the 4% pa interest on that $500,000 and at the end of the month adds the interest charged so that the balance becomes $501,667. At the same time, you make a monthly loan repayment (assuming P&I) of $2,387, leaving a balance of $499,280. From that day and beyond for the next month, interest is calculated on that end of month balance; and so on.

Let’s see what happens if you choose to make weekly loan payments instead of monthly repayments:

At day one, your loan balance is $500,000, at day 8 you make a repayment of $597 and the balance is $499,403 until day 15, when you make another repayment of $597 bringing your balance to $498,806, and again on day 22 your loan balance becomes $498,209, and on day 29, $497,612. Remember, that the bank calculates interest daily and charges it monthly. So, in this instance, instead of the interest being calculated for the entire 31 days of $500,000 - the interest is calculated for only 7 days at $500,000, the second week at $499,403, etc. In this first month, by paying weekly, you will save $26.10 in interest charges in the first month. This might seem small and insignificant… BUT…

… the benefit of making weekly loan repayments will continue throughout the life of the loan, and in this example could save you $56,692 in total interest charges and reduce your loan term by over 4 years!

ACTION: As an existing home owner, review your home loan repayments and if necessary make adjustments to weekly or fortnightly loan repayments instead of monthly repayments.

WHAT COMPOUND INTEREST MEANS TO YOU AS A FUTURE HOME OWNER… and whilst you might not yet own a home and therefore not have a loan, an understanding of the concept of compound interest is important as the same phenomenon occurs when depositing funds in the bank! However, this time significantly in your favour and particularly so if you are aware of the bank’s policy.

Let’s use an example of $50,000 sitting in a savings account earning 2%pa in interest. Your bank will choose to pay you interest on an annual, monthly or daily basis, depending on the policy of your savings account. If paid annually, after two years you will have earnt $20 in interest, whereas if paid monthly, you will have earnt double that amount!

ACTION: As an aspiring home owner, it’s important that you accumulate as much savings as possible so it’s important to maximise the amount of interest that your money earns by sitting in the bank. Therefore, as a responsible savings accumulator, review your savings accounts and ascertain how and when your bank is paying you interest; and if necessary, find an alternate savings account.