When you borrow money from a bank or credit card company, you will usually pay interest. Interest is the fee the lender charges to make a profit on the loan, and it is usually expressed as an annual rate percentage (APR). In general, the higher the APR, the more you can expect to pay for the loan.
For example, if you borrow $10,000 at an APR of 5 percent with a 10-year payment schedule, you will pay approximately $12,727.70 back to the lender. However, if you had borrowed the same amount at an APR of 10 percent with a 10-year payment schedule, you will pay $15,858.15 for the loan.
Compounding Interest 101
Compounding interest occurs when the amount of interest accrued on a loan is added back to the principal. Once the accrued interest has been added to the principal, or “compounded,” it begins to accrue its own interest. Over time, compounding interest can dramatically increase the cost of a loan.
For example, consider a $10,000 loan with an APR of 5 percent. For the sake of simplicity, assume the interest compounds annually. After the first year, the loan’s balance will increase by $500, assuming no payments are made. During the second year, however, the balance increases by $525 if no payments are made. During each subsequent year, the amount added back to the loan continues to climb.
Implications of Compounding Interest
Although compounding interest can be beneficial in the world of investments, the opposite is true when it comes to credit cards and student loans. Compounding interest causes these debts to increase in value quickly, especially if no payments are made on the loan while interest continues to accrue.
For example, consider the case of Students A and B. Both students take out a $10,000 student loan each year for four years with an APR of 7 percent. Student A defers his loan payments until the end of school, but Student B begins repayment immediately. He pays $116.11 each month until he graduates. Upon graduation:
- Student A will owe $44,399.43, while Student B will owe $39,912.85.
- Student A will be making a monthly payment of $515.52 for 10 years, while Student B will pay only $463.42 for 10 years.
- Student A will pay a total of $61,862.40 to the lender, while Student B will pay only $55,610.65.
This example demonstrates the power of compounding interest. Because Student B decides to begin making payments on his loans immediately, he reduces the amount of interest that accrues and, thus, the total amount he repays. Student A, on the other hand, paid much more in the long run because he chose to defer payments until after graduation.
Putting Compound Interest to Work for You
If you make the right choices, you can get control of compound interest. By paying as much as you can afford early in the life of your loan, you can reduce the total amount of interest you will pay, as well as the loan’s overall cost. For example, consider Student C, another student who takes out a $10,000 loan every year for four years with an APR of 7 percent. Student C decides to begin repayment immediately. Each month during school, he pays $116.11 plus an additional $100 toward the loan. At the end of four years:
- Student C owes $35,849.02, which is $4,063.83 less than Student B and $8,550.41 less than Student A.
- Student C’s payment required monthly payment is only $416.24, which is $47.18 less than Student B and $99.28 less than Student A.
- Student C’s total repayment amount will be $49,948.50.
- Thus, Student C was able to save a total of $11,913.90 by beginning payments immediately and paying a little extra each month.
In this economy, every dollar is important. By paying debts as quickly as possible, you can control compounding interest, eliminate debt sooner and save money.