There are two ways to calculate interest: simple interest and compound. Simple interest is a set percentage paid each year, while compound means you are paying interest on your interest each year. This can work for or against you, depending on if you are the one lending or borrowing the money.
To illustrate, let’s say you borrow $1,000 from me at 10% interest. Your payment is due at the end of the year, and at that point it becomes $1,100. Now if you don’t pay me at the end of our agreed upon interest period, you will owe me interest on the principal loan of $1,000, and also on the interest — $100 — from the first year. So, by the end of the second year, your debt becomes another $100 on the principal, and $10 on the interest, bringing the total up to $1210. If we continue at this rate for 7 years, I’ll have nearly doubled my money, making it a really good deal for me, not so much for you.
In practice, interest accrues more quickly than annually, often calculated quarterly or even monthly. When thinking about how this is executed by credit card companies, it becomes even more alarming: what happens if you miss a payment? You’re not only charged a late fee, but your interest rates also increase.
When thinking about how this relates to mortgages and student loans which assume several years of repayment, there is a lot of interest being paid on interest over time. So much so that it’s very likely you’ll be paying only the interest down for years, without even touching the principal loan. An amortization schedule is a table which will show how much of each payment is applied toward the principal balance and interest, and can be very shocking and eye-opening. For example, you’ll likely pay more in interest than on the principal loan if you have a 30-year mortgage.
This is obviously good for the bank, not for you.
The good news is that one extra payment per year can reduce your 30 year mortgage down to a 15- or 18-year mortgage, saving you a ton of cash.
With regard to student loan debt, you can essentially look at it like this: for every dollar you borrow, you’ll have to make $3 to repay it, due to interest and taxes.
This matters quite a bit, considering most students begin taking out loans their freshman year. So, if they take out an unsubsidized loan of $10K at a 6% rate, by the end of their first year they owe $10,600, and it just increases from there, paying interest immediately from the starting line of their schooling.
Your job is to be aware that you’re being sold, even on things as important as a college education. Remember, it’s someone’s job to get you in the door, sign you up, and add your name to the list of enrollees. It’s how they keep their job.
So, from this perspective, we invite you to consider your investments. An investment, by definition, is something that pays you back, year after year. College certainly has the potential to be an investment in yourself, where your earning power grows, but if you are giving so much away back to the lenders, what are you actually growing? You may be bettering yourself, but you have no guarantee that your earning power will be high enough to warrant such a huge cost.
Remember, compound interest works for and against you, and when it comes to life-changing, long-term cost, please do the math, do your research, and think long and hard before you sign your name on the dotted line.