What Is Compound Interest on a Loan?

Compound interest on a loan is calculated not only on the initial amount borrowed, known as the principal, but also on any accumulated interest from previous periods. This mechanism leads to the loan balance growing at an accelerating rate because you are essentially paying “interest on interest.” Understanding this concept is fundamental for anyone considering borrowing money, as it directly influences the total cost of a loan over time.

The Basics of Compound Interest

Compound interest operates distinctly from simple interest, which is calculated solely on the original principal amount of a loan. With compound interest, the accrued interest is added to the principal at regular intervals, known as compounding periods. The next interest calculation then applies to this new, larger balance. This continuous cycle means that the amount of interest owed can grow significantly over the loan’s duration.

Consider a hypothetical loan of $10,000 with a 10% annual interest rate. If this loan were to accrue simple interest, you would pay $1,000 in interest each year ($10,000 x 0.10).

With annual compounding, the first year’s interest of $1,000 is added to the principal, making the new balance $11,000. In the second year, the 10% interest is calculated on $11,000, amounting to $1,100, and in the third year, it’s calculated on $12,100, resulting in $1,210. This process yields a total interest of $3,310 over three years, which is $310 more than simple interest. The compounding period—whether annual, semi-annual, quarterly, or monthly—directly influences how rapidly interest accumulates.

Compound Interest in Different Loan Types

The application of compound interest varies across different loan products, largely depending on their terms and compounding frequency. The frequency with which interest compounds, such as daily or monthly, directly impacts the speed at which your loan balance can increase.

Credit cards are a prominent example where interest typically compounds daily. Interest charges are calculated and added to your balance each day, based on the average daily balance. Carrying a balance on a credit card can lead to rapid accumulation of interest because the unpaid interest quickly becomes part of the principal for subsequent interest calculations. Mortgages typically calculate interest daily on the outstanding principal balance, with payments applied monthly. True compounding, where unpaid interest is added to the principal to accrue more interest, usually occurs in mortgages only if payments are missed or under specific loan structures where interest is capitalized.

Auto loans generally operate on a simple interest basis, meaning interest is calculated solely on the remaining principal balance. As the principal is paid down, the amount of interest accrued decreases. Personal loans can vary, with some utilizing simple interest and others employing compound interest, often compounded monthly. The specific terms of any loan agreement will detail the compounding frequency.

How Compounding Affects Your Loan

The practical implication of compound interest for borrowers is a higher total cost over the loan’s lifetime. When interest compounds, the interest paid in earlier periods joins the principal, and subsequent interest calculations are based on this larger sum. This can lead to significantly more interest paid compared to a simple interest loan with the same rate and term.

Even minor differences in interest rates or compounding frequency can translate into substantial variations in the total amount repaid. For instance, a loan compounded daily will accrue more interest than one compounded monthly or annually, assuming the same annual percentage rate (APR). In long-term loans, such as mortgages, compound interest contributes to the amortization schedule, where a larger portion of early payments goes towards interest rather than reducing the principal. Over time, as the principal decreases, a greater share of each payment is allocated to the principal.