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An Introduction to Compound Interest and How High Interest Rates Can Cost You Dearly

Posted By:  |  October 14, 2014  |  0 Comment(s)

Interest Payments and debt

If you have loans, whether they’re personal loans, mortgage loans, or student loans, you probably know a thing or two about interest rates. Generally speaking, an interest rate is an added fee that you pay for the duration of your loan period for the privilege of having the loan, and it’s how lenders earn money. However, it’s important to understand that there are two kinds of interest rates: simple interest and compound interest. Here’s what you need to know about compound interest and how it might result in you repaying far more than what you borrowed.

Interest Rates: A Brief Overview

Whenever someone extends a loan, the lender takes on a significant amount of risk. First, there is the risk that the borrower may not repay the loan. Second, there is the risk associated with passing up other investment opportunities in order to extend the loan (opportunity cost). The lender must receive some form of compensation for taking on these risks. Whenever you borrow money from a bank or lender, or whenever you allow a bank or lender to borrow money from you in the form of an investment, the lender receives a fee over a specified period of time as compensation. This is, in essence, the basic concept of the interest rate.

Compound Interest: What It Is and How It Differs From Simple Interest

Simple interest and compound interest are two different types of interest that can accrue on a loan. Both kinds of interest are charged based on the loan’s outstanding balance, and both kinds of interest are expressed as a percent. However, simple interest is always calculated based on the loan principal at the very beginning of the repayment period. If you borrow $1,000 at a 10% simple interest rate that is calculated annually, then after one year you would owe $1,100, after two years you would owe $1,200, and after five years you would owe $1,500.

If the loan features a compound interest rate, though, you end up paying interest on interest. So if you borrow $1,000 at a 10% compound interest rate that is calculated annually, then after one year you would owe $1,100 and after two years you would owe $1,210. This is because that second year you paid 10% interest on a $1,100 loan even though the initial loan was only worth $1,000. After five years, you would owe $1,610.51.

A High Compound Interest Rate Can Create a Big Problem

If you have a loan with a compound interest rate, you will ultimately end up paying interest on interest. If that loan features a particularly high interest rate, such as 18%, it’s easy for the loan to grow out of control. For instance, if a $1,000 loan has an 18% compound interest rate that is calculated annually, then after one year you would owe $1,180. After three years you would owe $1,643, and after five years you would owe $2,287. There are several different kinds of compound interest products that have high rates, including payday loans and credit cards. If you don’t repay your lender in short order, the interest can quickly become unmanageable, and even turn into a larger problem than the loan’s principal!

If you’re looking for a loan to help you afford a home or car purchase, or if you just need some spare cash to get through an emergency, there are a variety of different loan options available to you. However, a number of loans today feature high compound interest rates, which can quickly turn your small stopgap loan into a big financial problem. If you can’t avoid getting a compound interest loan, make sure you pay it off quickly, before it has a chance to ruin you.


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