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Financial Friday: What Is Compound Interest, and How Does It Work?

Interest on student and credit card loans can be calculated two ways: as simple interest or as compound interest.

Betty Thorne, Stetson University

Betty Thorne, Ph.D.

According to Investopedia, simple interest is calculated only on the principal amount of a loan.  Compound interest is interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan. It can be thought of as “interest on interest.”

At a 10% simple interest rate, borrowing $100 would mean paying $10/interest every year. So, at the end of four years, you’d owe the original $100 + (4 x $10) = $140.

However, nearly all lenders use compound interest. With compound interest, you’d owe more. In the first year, you’d still owe $10 of interest. In the second year though, you’d owe 10% on the $100 you borrowed plus the $10 of last year’s interest. You’d owe $11 in interest for that year, and each year the amount of interest continues to rise.

Valrie Chambers, Ph.D., Stetson University professor

Valrie Chambers, Ph.D.

To get a better sense of how this escalates, see the tutorials at Khan academy.

Bottom line: if you have a choice between loans that begin accruing interest now, or loans that begin accruing interest after graduation, choose the latter. You’re not only saving money now, but because of compounding, you are likely saving a lot of money that won’t become evident until you graduate.

 

Valrie Chambers, Ph.D., professor of accounting, and Betty Thorne, Ph.D., professor of statistics and the Christian R. Lindback Chair of Business Administration, write Financial Fridays to bolster students’ financial wellness including preventing financial mistakes, safeguarding their assets and identity, and thinking critically about financial decisions.

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