How Compound Interest Affects Your Loan Payments

Compound interest can either be a great – or not so great – thing, depending on whether it’s in regards to investing, or owing money.

When it comes to investing, compound interest is one of your most effective tools. With compound interest, interest is accrued on both the initial principal investment, along with any interest that is earned each month. This makes it a wonderful tool for long term investing and financial planning.

However, the reverse can be said of compounding interest when it comes to things like credit cards, mortgages, student loans and other borrowed money. Compound interest significantly inflates the amount you might owe on a given loan, making it more difficult and arduous to pay off over time.

How does it work?

When you take out a loan, compound interest can significantly affect your repayment. Unlike savings, you want to minimize compound interest on loans to avoid higher costs. Here are some things that impact your loan and the amount you’ll end up paying over time.

1. Interest rates. 

The interest rate on your loan determines how much you pay over time. Higher rates lead to more interest, increasing your monthly payments. It's crucial to compare rates before choosing a loan.

2. Frequency of compounding.

Lenders compound interest differently, which impacts your total repayment. Some compound monthly, quarterly, or annually. The more frequently interest is compounded, the more you'll pay. Make sure you understand the compounding frequency when evaluating loan options either in your agreement or during the process of signing up for the loan 

3. Duration of your loan. 

Longer loans often mean more interest accumulates. Shortening your loan term, if possible, can save you money in the long run.

How do they differ based on the type of loan?

Every loan, with its terms, is different, and used for different things. You may automatically think of things like mortgages and student loans, but credit card debt can sneak up on you thanks to compound interest just as easily. Here are a few examples of compound interest in real-life scenarios.

1. Student loans.

Let’s say you have a student loan of $30,000 and an annual interest of 5%, compounded monthly. Over a 10-year repayment plan, you’ll end up paying back approximately $38,184 in total, meaning an extra $8,184 in interest alone. This is a great example of how a shorter loan term can help cut some of those costs. If you are able to pay it off in five years, you’ll pay about $34,677, which will save you over $3,500.

2. Mortgages. 

A $200,000 mortgage, with a 3.5% interest rate (interest rates vary greatly and are currently higher than this, but we’ll use this number for clarity’d sake). Compounded monthly, over 30 years. You'll pay around $123,312 in interest. If you choose a 15-year mortgage, on the other hand, you'll pay only about $57,357 in interest, saving a whopping almost $66,000. Saving time is your friend when it comes to compound interest on loans! 

3. Credit cards. 

Credit cards typically have higher interest rates that student loans or mortgages, sometimes exceeding 20%. While you may be approved for less of a loan than you would be on a student loan or mortgage, that number can add up – fast. If you have a $5,000 credit card balance with a 20% interest rate, that interest can quickly spiral out of control, especially if you are only able to make the minimum payment each month. Paying a bit more than the minimum, if possible, is a great way to get that debt a little bit more under control, since the compound interest will have a smaller total to compound onto.  

When can compound interest be a good thing? 

We’ve gone over the ways compound interest can wreak havoc on your finances, but it’s important to remember that it can also work in your favor when it comes to investing. Whether in high yield savings accounts, stocks, bonds, or other accounts, there are a few best practices to keep in mind to make the most of your investments. 

1. Start early! The sooner you begin investing, the more time your money has to grow. Even small contributions can make a significant difference long term.

2. Keep contributing. Once you start investing, try to get in the habit of continually depositing into your accounts. You can set up automatic contributions to help you stay on track.

3. Reinvest. When your investments generate dividends or interest, you can reinvest them to reach your maximum growth potential

4. Diversify. They say not to put all of your eggs in one basket, and the same can be said of investments. A diversified investment portfolio can help manage risk and enhance returns. You can invest in a wide range of assets like stocks, bonds and real estate. 

The bottom line 

Once you are equipped with an understanding of compound interest and how it affects loan payments, you can make sound financial decisions both when it comes to borrowing, and investing money.

Be sure to check out Stash’s extensive resources on compound interest, investing, financial literacy, loans and more to help you take control of your finances without any of the confusing language or pressure to spend.

Visit us at Stash.com or download the app to get moving on your financial journey.