Calculating Interest (snooze) Except It Is Really Important and Here’s Why

Let me start by asking a question:

if you take a loan out for $1000 at 5% APR for 5 years, do you think you will owe the lender $1000 plus $50 of interest for that 5 year period?

If you answer ‘YES’ you are not alone, but you are wrong. APR stands for Annual Percentage Rate, which means 5% is applied to the outstanding balance each year. At the risk of boring you rigid, this is called the Compounding effect.

This is not a math lesson and I’m not going to explain the Compounding here, but suffice it to say you owe a lot more than 5% of $1000 over the life of the loan in the example above.

In our sample loan, you borrowed $1000 over 5 year with an APR of 5%. You will owe about $100 in interest over the life of the loan (5 yrs.). Why does this matter? Because if you have credit card debt or you take out a consumer loan or HELOC to pay off credit card debt, you are going to pay A LOT more than the interest rate multiplied by the principal loan amount over the life of the loan, which MAY change your mind about the loan.

Also, it underscores the need to pay off debt as SOON as possible not just paying when you can. If you take out a $500k mortgage over 30 years at 3.75%, all of which would be considered perfectly reasonable, you will end up paying… you might want to sit down… $333k in interest over the 30 year life of that loan. Not pocket change.

You can see you do NOT pay $3.75% of the $500k you took out as a mortgage (which would equal $18,750). The compounding “pain” is generally worth it for a solid mortgage or student debt that allows you to earn more with your degree, but consumer loans should be a very last resort because of this hideous compounding effect.

On the other hand, compounding is your friend if you are a saver. If you save, especially when you are young, over time your savings grow A LOT. If you save $2000/year at age 30 until age 50 and earn 5%, you will have about $69k, not $2000 * 20 years plus 5%, (incidentally, that’s $42k).

Do not be fooled by low APR rates. Low APR rates are great, but remember another critical piece is how long it takes you to pay the loan back. Pay back quickly, save slowly over time.