Compound Interest in Borrowing
In the case of a loan, compounding accumulates interest on the outstanding principal plus the interest that was not paid during the previous compounding period. Compounding interest can generate escalating debt balances, which can sometimes get borrowers into trouble. When loans are compounded frequently, left outstanding for longer periods, or their interest/balances are not paid in full, the impact of compounding can be costly to the borrower.
To illustrate the effect of compounding on a loan, consider the example of a $10,000 loan at a nominal interest rate of 5% for a term of one year.
- Using the simple interest method, the borrower pays back the principal plus $500 in interest charges.
- If, however, the loan compounds interest quarterly, the borrower would pay $510 in interest charges at the end of the same year.
- If compounded monthly, the interest charge would be $512.
- If compounded daily, $513.
These seemingly small differences would grow rapidly for loans of longer terms. The longer the term, the larger the principal, or the higher the interest rate, the more drastic the differences will be.
Credit card issuers typically compound interest daily and charge it monthly. For this reason, carrying an outstanding balance on a credit card can become expensive.