Just as compound interest works wonders for you in accumulating increased earnings over an extended period of time, it can also be used by lenders to work against you. Instead of the money that you work for working for you, it would be paid over to your creditors as interest.
Specifically, just as compound interest earnings generate excellent growth in earnings over time, it will also grab your earnings for the benefit of the creditor who lent you the funds on a compound interest basis. The higher the interest rate and the longer the period, the more compound interest will devour your earnings.
The operation of a student loan will be used as the example, today:
Assume a student loan of $30 000 is advanced at the beginning of year one and interest is charged at a simple interest rate during the two-year period of study plus an additional year’s grace (a total of three years at simple interest) at six per cent and thereafter compounded interest is applied at the same six per cent rate.
Year Loan 6% $300/m
30 000 30 000
1 31 800 31 800
2 33 600 33 600
3 35 400 35 400
4 37 200 33 708
5 39 108 31 914
6 41 130 30 013
7 43 274 27 998
8 45 547 25 862
9 47 956 21 197
10 53 215 18 653
The first column sets out the number of years after taking the loan. Column 2 sets out the amount owed at the end of each year assuming no repayments are made. Column 3 sets out the amount owed at the end of each year assuming repayments start during year four at $300 per month.
For convenience in computing the amount owed, it is assumed that all interest and payment transactions occur at the end of the year.
In column 2, after the loan is taken, no repayments whatsoever are made. In the first three years while the student is still in university, interest is accrued at the simple interest rate of six per cent. In the fourth year, interest starts to accumulate on a compound basis on the original $30 000.
Column 2 represents the exposure of a security to the student loan where the student may graduate and then refuse to repay the loan as expected; the security then becomes liable for a $53 215 debt that is growing rapidly every year.
In column 3, repayments start during year four as $300 per month. So, even as compound interest starts to accumulate, repayment reduces the balance owing. By the end of year 10, the balance owing is $18 653. This represents a situation where the student after qualifying accepts the grace period but dutifully starts repayments.
Column 2 demonstrates the massive noose that is drawn around the neck of the student and his securities by compounding the loan interest after the grace period.
This example demonstrates that it is in the student’s interest to repay the loan as soon as possible, even starting to repay during the grace period.
The sooner the loan is paid down, the less interest there is to accumulate and compound during future years … and the more of the students income will be available to him to be saved and invested, hopefully on a compound interest basis.
• Louise Fairsave is a personal financial management advisor, providing practical advice on money and estate matters. Her advice is general in nature; readers should seek advice about their specific circumstances.
