Debt Consolidation Loan Debate: Home Equity Loans or Unsecured Loan?
By Maria Ny

Simple Interest versus Compounding Interest

Many people don't know the difference between simple interest and compounding interest. One of these two types of interest can cost thousands of extra dollars and the other shortens terms for paying off debt which will increase cash flow and save you money in the long run. Do you know the difference?

Simple Interest Definition: Simple interest is calculated only on the original loan principal and not on past interest paid.

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)

Imagine how much more that $10,000 loan at 8% for 5 years would be with these formulas. But, these still demonstrate fixed rate loan compounding. Remember, revolving credit lines are adjustable rate loans. So, at maturity, you'd be paying a lot more for that $10,000 line. The only way to determine approximately how much more is through amortization. Even then, you won't know for sure because you won't know the exact interest rate you'll be paying each time your loan adjusts.

Some people argue that a home equity line of credit (HELOC) is cheaper to get than a fixed rate second mortgage loan. Initially, it may be, but HELOCs are adjustable rate loans, so they end up being more expensive. So, if you already have a HELOC, it would probably be a good idea to convert the HELOC to a fixed rate loan.

In a recent article, the Federal Reserve claimed that "Americans carry around $5,800 in credit card debt from month to month. Making the minimum monthly payment on that debt would take 30 years to pay off, and include an additional $15,000 in interest." According to the Administrative Office of the Courts, 2,078,415 bankruptcies were filed in 2005; the largest number of bankruptcy petitions in the history of the federal courts. Since the bankruptcy laws were recently revised, people are looking for alternative ways of managing their debts.

Copyright Nationwide Mortgage Loan Company 2006 ©

 

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