Consider the risks and benefits of consolidating debt with a secure home equity loan and an unsecured personal loans. Both of these options present a good choice depending upon the situation.
Many individuals may not discern the disparity between simple interest and compounding interest, yet the dissimilarity between the two can translate to thousands of extra dollars spent or saved over time.
Understanding these interest types is crucial for optimizing financial decisions. Home equity loans and fixed rate personal loans are created with a simple interest amortization. HELOC loans and revolving credit cards have interest that compounds daily.
Simple Interest versus Compounding Interest
Let’s delve into the definitions and examples:
Simple Interest Definition:
Simple interest is computed solely on the initial loan principal, excluding any past interest payments. The formula for calculating simple interest is:
Compounding interest, on the other hand, is literally “interest on interest” because the interest from your previous balance gets tacked onto the original principal then more interest is calculated on the new balance.
Simple Interest Example
The following is the formula for simple interest:
P = principal (the initial amount borrowed)
r = annual rate of interest (percentage)
n = number of years (loan term)
A = amount paid at maturity (including interest)
A = P (1 + rn)
If you borrowed $10,000 for 5 years at 8% interest, the formula would look like this:
$14,000 = $10,000 × (1 + 0.08 × 5)
Compounding Interest Examples
The compounding interest examples below come from About.com Mathematics. They’ll illustrate how much more you would pay on a loan:
When the interest is compounded annually:
A = P × (1 + r) × n
If you borrowed $10,000 for 5 years at 8% interest and it was compounded yearly, the formula would look like this:
$54,000 = $10,000 × (1 + 0.08) × 5
The annual compounding already demonstrates how much more you would pay on the same $10,000 loan. However, credit cards do not have fixed interest rates. They have adjustable interest rates, and they’re a lot more than 8%, the current typical rate for a fixed interest second mortgage. Without going any further, you can see how simple interest is better for debt consolidation. However, many times, compounding interest does not just compound annually. Credit card interest is compounded more frequently, more like the following:
Quarterly = P × (1 + r/4)4 = (quarterly compounding)
Monthly = P × (1 + r/12)12 = (monthly compounding)
While some argue that home equity lines of credit (HELOCs) might initially seem more cost-effective, their adjustable nature could lead to increased expenses over time. With a rising interest rate scenario, converting a HELOC to a fixed-rate loan could be a prudent choice.
In light of the Federal Reserve’s findings that Americans carry substantial credit card debt, exploring alternatives to manage debt becomes imperative. The impact of minimum monthly payments on credit card debt and the potential interest accumulation underscore the need for informed financial decisions to avoid prolonged debt repayment periods. As bankruptcy laws undergo revisions, individuals seek viable strategies to navigate their financial challenges.
Article was written by Maria Ny, – Copyright BD Nationwide Mortgage 2006 ©
