Do you have a loan or mortgage to pay off? If you’re between the ages of 35 to 54, odds are you do.
What Is Simple Interest?
Simple interest is a fixed amount based on the principal, or original amount, of a loan or deposit. The interest amount remains the same throughout the entire repayment period.
For example, if simple interest is charged at five percent on a $10,000 loan over a three-year period, the amount of interest paid will be $500 each year, for a total of $1,500. Common examples of real-life simple interest loans are car loans, which are easy to calculate.
What Is Compound interest?
While simple interest lives up to its name, compound interest is more complex.
“Compound interest accrues on the principal amount and the accumulated interest of previous periods; it includes interest on interest, in other words,” Steven Nickolas explains in an article for Investopedia.
If the $10,000 loan described above involved compound interest rather than simple interest, the total interest paid after three years would be $1,576.25 instead. That’s because the interest owed each year is calculated based on the original loan plus the interest paid in the previous year.
This also means that compounding interest scales significantly with frequent compounding periods, potentially even more so than with higher interest rates.
“For every $100 of a loan over a certain period, the amount of interest accrued at 10 percent annually will be lower than interest accrued at five percent semi-annually, which will, in turn, be lower than interest accrued at two-and-a-half percent quarterly,” Nicholas writes.
Related: See how to finance your new home with a grant or loan >>
How Interest Affects Loans
Interest can work in your favor, too. Chances are, financial experts or people you know have encouraged you to start saving for retirement while you’re young. Not only does this give you more time to put money into your retirement fund, it means that compound interest enables you to save exponentially more money by starting earlier.
The same is true in reverse when repaying loans. The earlier you start, and the more frequently you make payments, the less money you will have to pay over the total period. It’s best to pay off loans as quickly as possible, as debt compounded over the years can spiral out of control.
“Pay off debts quickly, and pay extra when you can,” Justin Pritchard advises in an article for TheBalance.com. “Paying the minimum on your credit cards will cost you dearly because you’ll barely make a dent in the interest charges, and your balance could actually grow.”
As with all loans, you should always seek the lowest interest rates you can find. Keep in mind that even with a low rate, compound interest can quickly make a loan overbearing to repay.
“If you have student loans, avoid capitalizing interest charges and pay at least the interest as it accrues so you don’t get a nasty surprise after graduation,” Pritchard says. “Even if you’re not required to pay, you’ll do yourself a favor by minimizing your lifetime interest costs.”
Compounding is a powerful force that can work for you if you invest early and regularly. And if you have a loan that has to be repaid with compound interest, you can save money by paying it back early and increasing the frequency of your loan repayments.
Need Help Planning for Future Financial Goals?
Besides paying off any loans and interest you have, it’s important to plan for the future – whether that means buying a home, sending children to college or saving for retirement.
Wondering where to get started? Try one of our financial planning calculator tools. They’ll give you personalized tips for managing debt, planning for retirement and saving more every day.
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