How Does Compound Interest Work?

The price of a student loan can add up quickly due to the principle of compounding interest.  Assume that you take out a student loan your freshman year of $10,000 with a fixed interest rate of 6%.  At the end of the year, you will owe  dollars in interest.  If you do not pay this interest it is added to the balance of the loan, bringing you loan total to $10,600.

 

Now we can demonstrate the principle of compounding.  Assuming that you have not paid back any of the loan by the end of the second year, the amount of interest charged will be .  The new cost of the loan is now. The interest cost of the second year increased by $36 over the first year because you are now paying 6% on the cost of the interest of $600 from the first year of the loan.  Compound interest describes the fact that you will not just be charged 6% on the original $10,000, but rather that you will be charged 6% on the original $10,000 plus any subsequent interest charges.

  

The following table shows what the cost of your loan will have increased to over ten years.  Year four corresponds to the cost of the loan upon receiving your bachelor’s degree, and year nine corresponds to the cost of the loan after a 5 year graduate program.  Similar calculations can be done for any loan amount at this website.The numbers used to get the loan cost after 10 years would be Principle=10000, Rate=6, Years=10.

 

Additional resources can be found here.