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Quick Overview of Banking Interest

I’ve been following the Dreamhost saga mostly from curiosity. I would have been liable to an accidental site shut-down, but don’t trust anyone with things like automatic billing.

Some of the comments are frightening. One set scare me because they seem to believe that Dreamhost was trying to seriously scam its customers by doing this. Actually, they had an imperfect program which had worked well for years but was vulnerable to typos. Typos that we all make around the new year, I might add!

The second set is even scarier because their posts demonstrate a profound undereducation about pretty important subjects. In particular, one on bank interest caught my eye:

What would be the daily interest on an account holding, say, 2.5 million? [the amount they overcharged]

2.5 million x 2% interest = $50,000 per day

Its been 4 days almost, so thats around $200,000 in interest (free money), if its a 2% rate, which is around average. PLENTY of money to give back to those who have overdraft fees and bounced check fees.

All I can say is “Where do I sign up?” Seriously, 2% free money every day? Apparently it’s not compounded, but who cares. If I put in $1000, I’ll have $20 new dollars a day. Dude, if I put in $10,000 I’d never have to work again!

They must find bank statements pretty confusing.

But consider credit cards–there you’re paying 13% interest—so for every day I have a $100 balance, I owe another $13. That would swamp and kill me in no time.

I don’t think the user is necessarily dumb, just not educated about how interest and the banking industry works. And lack of education here can be crippling.

Almost all bank interest is APY—annual percentage yield. My money at ING will earn about 4% each year. So if I had $1000 in there all year, I’d get $40 for that. And if I put in another $1000 6 months into the year, I’d get $20 for that ( 6 months/12 months = .5 .04 * .5 = .02 = 2%). If I put in another $1000 only for the last month, I’d get $3.33. That’s the amount I would have earned on the money by December.

Now banks do periodically compound it, so maybe 1/4 of the way through the year I’d get $10 for that first $1000 and then in the next quarter I’d get interest paid on $1010.

But the principle is pretty simple—everything is based on the year.

In the same way, credit card interest is APR—annual percentage rate. Your company decides when to apply the interest. Maybe if you’re at 12% you get 1% added on each month…and that 1% will be part of the next month’s bill, unless you pay it down. So if your balance is $1000, you’ll get $10 tacked on. And if you pay down $25, the next month, you’ll still have a balance of $985 ($1000+10-25=985) and get $9.85 tacked on your next statement. And that’s if you didn’t add anything.

They might compound more or less often depending on what they’re after. Weekly compounding might bring in more money, for instance. Unfortunately, I’m too sleepy to calculate it.

I’m writing this late, so please let me know if I messed up any calculations.

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Lily January 22, 2008 at 11:09 pm

I didn’t check your math but your principles are correct. There really needs to be some basic PF education. APY is the key metric in so many aspects of personal finance that understanding it is very important. Hopefully your post clarified matters for some of the previously uninformed.

RacerX January 22, 2008 at 11:44 pm

Math tip #2

The other thing you can add is multiple years by using ^ . In other words, simple interest over ten years would be: P*1.03^5 This would be the principle over 5 years (simple interest).

S if you wanted to see how much $1000 1970 dollars where today (using 3$ for inflation):

Amount*Inflation^Years=Today’s Dollars
$1000*1.03^38= $3074.78

Early Retirement Extreme January 23, 2008 at 12:24 am

Compounding can happen in a daily, monthly, quarterly, semiannually, annually or continuously. If the stated yield (what is usually listed) is 6% and it is compounded monthly (this is the usual thing for bank account), you use an effective annual yield of (1+0.06/12)^12-1. This is slightly higher than the stated yield. I have not seen any place that compound continuously but it’s a good approximation to daily compounding which is what credit card companies do. Money market yields are slightly weird in that they compound on a 360 day year. I think CD yields are the same way.

Jim January 23, 2008 at 6:29 am

Most poeple forget about the time factor. Thus the bad math.

Dad January 23, 2008 at 9:30 am

Pretty good. Especially for bank deposit interest. Credit Card interest is calculated on a daily interest rate (APY / 365). However, compounding on it usually takes place once a month on the billing cycle when the interest is added to the bill.

deepali January 23, 2008 at 11:38 am

Great post. I am often confused by credit card interest, because it compounds daily but posts monthly.

SavingDiva January 23, 2008 at 12:01 pm

I would be extremely frustrated if I was misbilled…Usually I have automatic billing set-up to one of my credit cards…then I just pay that off…I score points too 🙂

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