Understanding the Impact of Compound Interest

When you borrow money, your financial institution calculates compound interest on both the initial principal and the accumulated interest from previous periods.  Essentially, debt grows faster because interest is earned on interest. The number of compounding periods (annually, semi-annually, quarterly, monthly, daily) makes a significant difference. Generally, the higher the number of compounding periods, the greater the amount of compound interest.

This contrasts with simple interest, which financial institutions calculate only on the principal amount. Debt grows more slowly because you pay interest on the principal only.  Interest is constant over time and does not compound.

The impact of compound interest on loans is higher total cost.  Because interest compounds, the total amount you will pay over the life of the loan is higher compared to simple interest loans.  Your monthly payments may include both principal and accrued interest, and the amount of interest can vary depending on how frequently it compounds.

Suppose you borrow $10,000 at a 10 percent annual interest rate with the principal and interest due as a lump sum in three years. 

If the loan attracts simple interest, the calculation will be as follows:

Year 1: $10,000 times 10% = $1,000

Year 2: $10,000 times 10% = $1,000

Year 3: $10,000 times 10% = $1,000

Total interest: $3,000. 

Total repayment: $13,000 ($10,000 plus $3,000)

However, if the loan attracts compound interest, the calculation will be as follows:

Year 1: $10,000 times 10% = $1,000

Year 2: $11,000 ($10,000 plus $1,000) times 10% = $1,100

Year 3: $12,100 ($11,000 plus $1,100) times 10% = $1,210

Total interest: $3,310. 

Total repayment: $13,310 ($10,000 plus $3,3,10)

You end up paying $310 more with compound interest.  In this example, a three-year loan with interest compounded once a year was used. However, if interest is compounded more frequently and for a longer term, the difference between compound and simple interest increases. 

Tips for Managing Loans with Compound Interest

• Understand the terms.  Know how often interest is compounded. Understand the difference between Annual Percentage Rate (APR) and Annual Percentage Yield (APY).  APR does not include compound interest effects, while APY reflects the effects of compounding. Compare these to understand the true cost. Online loan calculators can help you estimate future payments and total interest costs based on different compounding frequencies.
• Pay on time.  Regular payments reduce the principal amount and minimise the amount of interest that compounds.  If possible, make extra payments toward the principal to reduce the amount of interest that accrues.   
• Consider refinancing.  If you have a high-interest loan, refinancing to a loan with a lower interest rate can reduce the amount of compound interest.
• Understanding compound interest and how it impacts your loans can help you make informed financial decisions and manage your debt more effectively.