The Ultimate Guide On Understanding Compound Interest On Personal Loans

Personal loans can be a useful tool to finance some of life’s biggest expenses. Whether you need to cover a big medical bill, pay for a wedding, or buy a new car, personal loans can provide you with the money that you need. 

However, understanding how personal loan interest works is essential before you take out a loan. One key concept to understand is compound interest.

What is Compound Interest?

Compound interest is interest that is calculated on both the principal amount and any interest earned over time. It is commonly understood as interest on interest. This means that, with compound interest, the interest owed grows exponentially over time. Compound interest differs from simple interest, which only accrues interest on the principal amount borrowed.

To illustrate how compound interest works on a personal loan, let’s assume that you have taken out a $10,000 loan for five years at a fixed interest rate of 7%. With simple interest, you would only pay interest on the $10,000 principal amount, which would result in total interest payments of $3,500 ($10,000 x 0.07 x 5 years). However, with compound interest, the interest payments would be calculated on the principal amount plus any interest earned over time.

At the end of the first year, you would owe $10,700 ($10,000 principal amount + $700 in interest). At the end of the second year, you would owe $11,449 ($10,700 principal amount + $749 in interest). Over the five-year term of the loan, your total interest payments would amount to $2,837.09. This is more than $600 less than the total interest payments under simple interest.

Compound interest can be advantageous for savers but can be a disadvantage for borrowers. Borrowers pay interest on their outstanding balance, which increases with every interest payment made. Therefore, the longer it takes to repay a loan, the more interest you will end up paying.

How Is Compound Interest Calculated On A Personal Loan?

The formula used to calculate compound interest on a personal loan is A = P (1+r/n) ^ nt, where A is the total amount owed, P is the principal amount, r is the annual interest rate, n is the number of times interest is compounded per year, and t is the number of years in the loan term.

Here’s how this formula would apply to our hypothetical $10,000 loan for five years at a fixed interest rate of 7%, compounded annually:

A = 10,000(1+0.07/1)^(1×5)
A = 10,000(1.07)^5
A = 10,000(1.4026)
A = $14,026

Therefore, over the five-year term of the loan, you would pay $4,026 in interest.

How Can You Minimize Compound Interest On A Personal Loan?

While compound interest can’t be avoided on a personal loan, there are several ways you can minimize your interest payments:

Pay Bi-Weekly Instead of Monthly – Paying bi-weekly instead of monthly can help reduce the amount of interest you pay. Because interest is calculated based on the outstanding balance, making payments more frequently can help reduce the amount of interest you owe.

Make Larger Payments – Making larger payments than minimum payments can help reduce your loan balance faster, which in turn reduces the amount of interest you will owe.

Refinance Your Loan – Refinancing your loan can help you get a lower interest rate, which can reduce the amount of interest you will owe over the term of the loan.

Pay Your Loan Off Early – Paying off your loan early can help reduce the interest you owe. However, some lenders charge prepayment penalties, so make sure you understand the terms of your loan before making extra payments.

Understanding compound interest is essential before taking out a personal loan. While compound interest can be advantageous for savers, borrowers need to be aware of the amount of interest they will pay over the term of a loan. By taking steps to minimize compound interest, you can reduce the amount of interest you owe and save money in the long run.