The American dream is still alive and well, with goals like owning a home and paying for children’s college education at the top of many financial wish lists. However, with college costs and home prices continuing to soar, the amount of debt we’re taking on has increased as well. In fact, the average American will pay more than $600,000 in interest over the course of a lifetime.1 So how do you figure out the difference between “good debt” and “bad debt?” And how do you get OUT of debt? Getting a handle on how interest rates work is a good place to start.

First, let’s get some of the lingo straight.

  • Lender: The individual or company that loans you money with the expectation that they will be paid back.
  • Principal: The amount of money borrowed.
  • Annual Percentage Rate (APR): The amount of interest you’ll pay on your loan each year.
  • Fixed Interest Rate: An interest rate that doesn’t change during the lifetime of the loan.
  • Variable Interest Rate: An interest rate that changes over time, usually along with an index such as the prime rate or federal funds rate.

Now that we know the lingo, we can get into what interest is and how it works. Interest is what lenders charge when they loan money to someone else. Why do they do this? Instead of using their funds for something else, such as investing or buying another asset, they’ve loaned it to you. What’s in it for them? Interest. They charge interest based on an interest rate, which is typically a percentage of the amount borrowed.

Let’s say you take out a five-year, $5,000 loan with a 3% APR. Your interest rate is 3%, and by using a simple interest equation, we can calculate how much you’ll owe at the end of the life of the loan.

$5,000 (principal) x 3% (annual interest rate) x 5 (the number of years in which you agreed to pay back the loan) = $750.

With your fixed 3% interest rate, this means you’ll pay an additional $750 in interest over the five-year lifetime of the loan, meaning you’d pay back $5,750 total.

Seems easy enough, right? If only it were always that simple.

Enter compound interest. We’ve talked about compounding before and explained how it can help your investments grow. But when it comes to your debt, compounding is not your friend. Compound interest means that you have to pay interest not only on the amount you initially borrowed, but also on any accumulated interest! In other words, any loan interest you don’t pay off gets added on top of the loan principal — and you now have to pay interest on that new higher amount. Essentially, you’re paying interest on your interest.

Compound interest is assessed during regular intervals known as compounding periods. Based on the terms of your loan agreement, this can be either annually, semi-annually, quarterly, or monthly. Depending on the frequency of your compounding periods, you could end up paying back a lot more than you initially borrowed.

Consider this example: The average credit-card APR reached 16.15% in 2017.2 Take our $5,000 scenario from earlier but add monthly compounding at 16.15%. You could end up paying more than $7,415 if you’re making the minimum monthly payment needed to remain in good standing with the credit-card company.3

OK, got it. Now what?

Debt isn’t necessarily all bad, especially if you’re managing it responsibly. Just be sure you understand how interest rates and compounding periods factor into the equation. Read the fine print, consider the timeline of when you can expect to pay off your loan, and run calculations. This knowledge can help you prioritize which debts to focus on paying down first or even provide motivation to refinance or pay down debts faster.

Once you’ve gotten a handle on the terms of all your loans, make a plan for how you’ll tackle your debt. Consider the interest rates you’re being charged as you make your plan: debt with the highest interest rates (“bad debt”) not only packs a wallop, it also ties up money that could otherwise be used to invest or make progress towards short-term savings goals. By focusing on getting rid of your high-interest debt, you can start putting the power of compounding to work for you instead of against you.

 

1 Yeager, J. (May 7, 2012). A Lifetime of Debt. AARP. Retrieved September 21, 2017, http://blog.aarp.org/2012/05/07/a-lifetime-of-debt/
2 https://www.creditcards.com/credit-card-news/interest-rate-report-92017-up-2121.php
3 For each month, Credit.com calculates and adds the interest accrued during that month to the amount owed during the previous month. Then they subtract the monthly payment to arrive at the new amount owed. They repeat the process and track the amount of time needed for the amount owed to reach $0. Note that Credit.com is a third-party website and Financial Engines is not responsible for information or interactions that occur there.
CPY20451