Why Compound Interest on Loans Causes Problems: High Interest Rates and Low Repayments Make Clearing Debt Difficult

What is Compound Interest?

Compound interest is where interest in the second and subsequent period is charged on both the capital amount and the interest that has accrued to date. In the case of a loan it will be reduced by any repayments that have been made in the period. Where the repayments are small they may barely cover, if at all, the interest charged in the period so extend the period of the loan and thereby the amount of interest paid.

Why Paying off a Credit Card is So Difficult

The impact of small repayments and high rates of interest being compounded on a debt can be demonstrated with a not unusual credit card balance of £10,000 with an interest rate of 20%. Many credit and store cards charge more and some types of loans several times more.

If the borrower pays off a minimum monthly payment of 2% (£200) of the initial outstanding balance and then maintains a £200 per month repayment rate it will take 9 years to clear that debt. That is without adding any new debt or reducing repayments as the outstanding balance falls. The borrower will have paid almost £12,000 in interest in that time – an average of over £1,200 a year.

Paying the minimum each month prolongs the pain considerably. If the borrower reduces their payments in line with the minimum payment, the greater of 2% or £10, the repayment period will extend substantially – to an eye-watering 84 years, a lifetime. If the interest rate is 24% making a 2% minimum repayment will not reduce the loan at all. If the interest rate is higher, which on some credit cards and many store cards it is, then a minimum 2% payment will result in the debt increasing. It therefore makes sense to ensure the debt is at the lowest rate possible.
If the borrower can pay just an extra £50 per month (£250) then the debt is cleared in five and a half years and the total interest paid is also almost halved.

Saving Makes Much More Sense

If instead of having to use it repay a debt £200 a month had been saved in a savings account paying just 4% per month interest then in the nine years it took to repay £10,000 the saver would have a lump sum of over £25,000. In high interest savings accounts or other high yield investments paying earning say 10% per year the result would have been over £33,000.

Make the Maximum Repayment that can be Afforded

A borrower should therefore repay the maximum amount that can be afforded and not simply the minimum that is required. Otherwise the interest paid for no benefit will balloon as the period of indebtedness extends. As has been shown the borrower will benefit enormously by making short term lifestyle sacrifices for earlier repayment and having the use of the money rather than paying it out as interest.