Compounding Interest What does this mean for us?

Scenario Suppose someone offers to loan you $100,000 for one year, and he tells you that he will charge you 6 percent interest. How much will you have to pay him one year from today?

Answer? How much do you owe on this loan one year later? The lender wants his money back ($100,000) plus 6 percent of the principal, which is $6,000 interest. So you owe him $106,000 at the maturity date of the loan. You had the use of $100,000 for one year and pay $6,000 in interest for that privilege. The lender gave up the use of the money for one year and earned $6,000 interest income.

Scenario Say that you need the money for two years instead of one. Because of the longer time period, the lender might demand a higher interest rate, say 6.5 percent. At the end of the first year you pay him $6,500 interest, and at the end of the second year you pay him $106,500, which consists of $6,500 interest for the second year and the $100,000 payoff of the principal.

Continuing… Let’s say you want to borrow the 100,000 dollars for two years with NO interest payments…this means you don’t want to make any payments on the borrowed money until the two year time period has ended.

What is compounding already??? The loan was given with the understanding you would pay the 6.5 percent interest at the end of each year…you chose not to do this, so you NOW owe interest on that amount as well! It is compounding…yikes!

What the numbers say… $106,500 Principal Balance x 6.5% Interest Rate = $6, Second Year Interest

Recap… We borrowed $100,000 A two year loan at 6.5 APR We opted to not make ANY interest payments during those two years How much did this loan cost us?

Answer…. With compounding interest the total amount we would owe at the end of the loan term would be 106, It cost 6, to borrow 100,000!

Reflect… Imagine if this example had been reversed, if you had invested that amount of money at that rate, you would have made 6,922.50!