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Accrued interest can either add to your debt or help you build wealth, depending on the type of account you're dealing with.
With most types of debt, borrowers are not only expected to repay the amount they initially borrowed, but must cover interest charges that accrue on top of it. On the other hand, savings accounts and investments can accrue interest that's paid out to you, known as a yield.
What does all of this mean for you? Here's what you should know.
What Is Accrued Interest?
There are different types of interest you may pay or earn, whether it's on a loan, a credit card, an investment or a savings account.
If you're borrowing money, the interest and any fees that you pay are considered to be the cost of borrowing. In contrast, if you have a deposit account or you've invested in bonds, the interest you earn is the cost that the financial institution, corporation or government agency pays to you as their cost of borrowing.
If you have a loan or a credit card, interest will accrue each day. Installment loans typically accrue interest at a daily rate and it is then included in the monthly payment amount. With credit cards, interest accrues daily but isn't applied to the account's balance if you pay off your monthly bill in full.
The amount of interest that accrues is based on your interest rate and your principal balance.
Accounts that earn interest, such as high-yield savings accounts and certificates of deposit, also typically accrue interest daily, but the yield is based on your average daily balance.
If you've invested in a bond, interest doesn't accrue as it does with a loan. Instead, you'll typically receive a fixed interest payment quarterly, semiannually or annually.
What Is Deferred Interest?
Some retailers and store credit cards offer 0% financing promotions that are really deferred interest arrangements. With this setup, you have a set period during which you can make payments toward your balance without any interest charges attached.
However, interest is still accruing during this period, and if you don't pay off the purchase in full by the end of the promotional period, you'll be assessed the amount of interest that's accrued.
This is not true, however, for cards that offer an introductory 0% APR on purchases and balance transfer credit cards that have a 0% intro APR. These cards offer true 0% APR promotions, which means that if you can't pay your balance in full by the end of the introductory period, you'll only be assessed interest on the remaining balance. Your balance won't include any accrued interest from the date you started using the promotion to the date it ended.
How Is Accrued Interest Calculated
The way interest accrues can vary depending on the lender and the type of loan. With credit cards, for instance, card issuers convert your APR (annual percentage rate) to a daily interest rate by dividing it by 365 or, in some cases, 360. Then, you'll add up your balance at the end of each day in a statement cycle and divide that number by the number of days in the statement period.
Multiply your average daily balance by your daily interest rate, then multiply the result by the number of days in the billing cycle to get your total accrued interest for the period.
Regardless of whether you use a credit card or a loan to get the financing you need, it's important to know how much the final cost will be after adding in interest and fees. To determine your total cost, it's a good idea to use an interest calculator for loans or credit cards.
How to Pay as Little Interest as Possible
While interest is a given with some types of loans, that's not always the case. And even if you're being charged interest, there are ways to reduce your total charges. Here are a few tips to help you get started:
- Pay your credit cards in full. Paying your credit cards on time and in full is not only important to building and maintaining good credit, but it also ensures that you avoid interest. You'll get a grace period between your statement date and due date. Make it a goal to pay off your balance completely during that time.
- Make more frequent payments. If you have an installment loan like a mortgage or car loan, making payments more frequently can stop interest from accruing as much throughout the month. What's more, it can help you pay down your debt faster.
- Build your credit history. Building and maintaining exceptional credit can help improve your chances of securing lower interest rates on both loans and credit cards. Over the long term, having excellent credit can save you thousands or even tens of thousands of dollars in interest charges.
- Have a plan for your debt payoff. If you have multiple balances that you want to pay off, consider using the debt avalanche method or debt snowball method to prioritize your repayment plan.
- Refinance your loan. If you have student loans, a mortgage or an auto loan, refinancing your debt could help you score a lower interest rate. Before you try, though, check your credit score to see if it's improved since you first took out the loan. You should also see if market interest rates have gone up or down in the meantime.
The Bottom Line
If you're borrowing money, interest is often a given. The good news is that you can take steps to limit how much you spend on interest charges, both on your current credit accounts, as well as on future loans and credit cards.
As you work to improve your credit and take other steps to reduce interest charges, monitor your credit regularly to stay on top of your credit and address potential issues as they arise instead of waiting until they've done significant damage.
Building credit and paying off debt can take time, but the savings and peace of mind are well worth the effort.