Whether you are taking out student loans, a mortgage, or a personal loan, understanding how interest works is an important part of assessing the terms on any loan.
For example, one could reasonably think that taking out a $15,000 loan with 5% interest might end up costing close to $15,750 because 5% of $15,000 is $750. But this would be wrong, depending on how long it takes you to pay it off, it might look more like $20,000 when you finish paying it off.
Understanding basic terms
When you borrow money, the principal is the actual amount of money you are borrowing. The interest rate is the percentage of the principal you are being charged for borrowing that amount.
What factors influence the interest rate?
Interest rates can vary widely depending on the type of loan. While automobile and home loans currently start around 3%, the interest rate for federal undergraduate student loans increased to 5% in 2017, and credit card interest averaged 16%. Other factors that can impact the amount of interest you owe are the length of time taken to repay the loan, as well as whether the loan is subsidized by the government (federal loans).
What is compounding interest?
When you take out a loan, you should look at how the interest accrues — as in, whether the interest is charged daily, monthly, or annually. Compounding interest is interest that builds on top of your interest.
To understand how this works, let’s imagine you took out a $10,000 student loan with a 4.45% interest rate that accrues daily. The interest continues to build every day of the year. Therefore, your daily interest rate is about 0.012% - this comes out to $1.20 per day ($10,000*0.012% = $1.20). The following day, your new loan balance climbs to $10,001.2. When another 0.012% of interest is added the following day, it will be on this new amount.
By the end of the year, you owe $455.02 in interest on your student loan, rather than the $445 you’d pay if your interest was compounded just once a year instead of daily.
How do I reduce interest paid?
There are several steps you can take to reduce the amount of interest you have to pay. When you receive your monthly loan statement, paying more than the monthly minimum will cover the interest that has compounded, and will reduce your remaining principal on the loan. Budgeting as little as an extra $20 to $30 per month above your minimum balance can end up saving you hundreds of dollars in the long run. If you have multiple loans with different interest rates, aim to pay off the loans with the highest interest rate first by covering the minimum balance on all loans and putting the extra payment amount towards your highest interest loan.
Here is an online calculator to help you calculate how much more quickly you can pay off your debt by making extra payments.