Compound interest is interest on top of interest. When you take out a loan with compound interest, you pay interest on the principal, and then the compounded interest is an additional rate you pay on the accumulating interest. In a savings situation, compound interest will help you get to where you want to go faster, but when it comes to loans, compound interest adds up quick. For example, if you paid semi-annual compound interest, the amount of interest you would pay over six months would be added to your original balance to create a new total on which interest is calculated. Without proper management, it can be a debt-accelerator.
When taking out a mortgage, compound interest can result in the mortgage being doubled or even tripled over the life of the loan, depending on your mortgage and payment history. In a savings situation, interest is usually compounded annually – that is the interest is added on to the principal once a year. In a mortgage situation, not surprisingly, the interest is normally compounded semi-annually, causing the principal amount of your loan to increase every six months.
In the early days of your mortgage, you are mostly paying the interest off, while touching very little of the actual principal. The higher interest rates, the more impact compound interest is going to have on your loan.
To get a good idea of what your mortgage might look like over time, try using an online mortgage calculator and experimenting with different rates and variables. To get an idea of how compound interest will affect your loan, using the Compound Interest Rule of 72: divide 72 by the percentage of interest on your loan to determine the point at which it will double. For example, if you had a $100,000 mortgage, and an 8 per cent interest rate, your mortgage would double in 9 years, if the interest rate remained unchanged and you didn’t repay any of the principal: 72 divided by 8 = 9.
Minimizing the amount of compound interest you pay is a very important part of managing your debt. Consider the following tips if it looks like your compound interest payments might be deadly:
• Look at a smaller property with a smaller mortgage
• Keeping the amortization period of your loan as short as possible and decreasing that period every time it’s up for renewal will help keep interest in check.
• Pay more on your mortgage or make more frequent payments whenever possible.
• If the opportunity comes up to make a lump sum payment, you will significantly decrease your debt and interest rates over time.
Nelson Goulart
Broker of Record with Signature Service GMAC Real Estate
www.infomarketgroup.com
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