Understanding Compounding Interest on Loans


For every loans that you make, you will be incurring interest on top of the principal. This is the method used by lenders and financial institutions in order to earn money from you. The amount of interest they would charge depends on many factors, but technically, it’s a measure of how much a risk they consider you to be.

The Simple Formula

You can calculate the amount of interest your debt will accrue by simply multiplying the interest rate by the principal amount that you owe. For instance, if the interest rate is 10% — this is for demonstrative purposes only – and the principal amount is $2,500, doing the formula yields a total of $250 in interest.

You can then add the interest to the principal in order to come up with the final repayment amount. In this case, you owe the lender a total of $2,750 at the end of your loan term.

As mentioned earlier, lenders charge interest as a means of protecting themselves from losses due to non-payment of your obligations. Some institutions thus implement compound interest in response to late payments of loans.

It’s important to understand compound interest. If you understand how it works, you can understand the risks you could be exposed to the moment you decide to take out a loan from a financial institution. This is also why it’s important that you read the fine print before you sign the contract, because this is where you can find if the lender charges compounding interest.

Okay, so let’s move on to the definition of compound interest, and how it could affect your risk exposure when taking out loans.

The Mechanics of Compound Interest

The Balance defines compound interest as interest that is slapped on to money that has already accumulated interest previously.

Following the formula of calculating the amount of interest, let’s say that the debtor charges a 5% compounding interest every week in the event of a default or non-payment of obligation. This means that, after accumulating interest of $250 on the $2,500 previously owed, you will have to pay an additional 5% on top of the total amount every week if you are unable to settle the debt on time.

This is what will happen – if you miss your payment after the due date, you will have to pay an additional $137.50 on top of the $2,750 you already owed. Your new balance is now $2887.50.

Let’s say you still failed to settle the balance after another week. You will have to pay another $144.38 in compounding interest, bring your total amount owed to $3031.88. The total interest for your loan has grown to $531.88 over a period of two weeks.

Again – read the fine print or, better yet, talk to the loan specialist regarding late fees and compounding interest. It’s not that you intend to default or be late with your payments, but you’d have to understand early on what lies in store for you in the unfortunate event that you are unable to settle on time.

Compounding can also be applied on investments, and it can maximize profits in that context. That should be a topic for another article, however.

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