When you take out a loan, you usually have to pay off the sum you borrowed - the principal - and a percentage of that amount as interest. This is normally done via one or several payments made over a pre-set timescale.
Compound interest works slightly differently. Instead of paying the same amount of money at regular intervals, you’ll have to pay an ever-increasing amount of money on each payment date.
The reason for this is that your interest payment will be based on the principal plus the prior interest payment you made. This is easy to understand when you see it in an example.
Let’s say someone borrowed £10,000 that had to be paid back at the end of ten years, with an annual interest rate of 2 per cent per.
With a normal loan that would mean the borrower would have to pay interest of £200 for each of those ten years. Add that to the principal and, at the end of ten year period, the borrower would have to pay back £12,000.
If someone took the same loan but had to pay compound interest, things would look slightly different:
As you can see, the borrower will end up having to pay £12,189.94, slightly more than the regular loan which would have ended up costing £12,000.
A difference of £189.94 isn’t too bad but if a loan has a higher and more frequent interest rate, it can make borrowing very, very expensive.
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