Paying off a loan can be quite challenging in itself. When you are also paying compound interest, it can become even harder as you may end up paying a lot of extra money in interest.
Compound interest, as opposed to simple interest, is the interest you pay on the principal amount you borrowed and on any interest accrued in the previous period.
There are a few things to keep in mind when you have a loan with compound interest to avoid having to pay exorbitant amounts of extra money.
Pay attention to the frequency of compounding
Compound interest can accrue daily, monthly, quarterly, or yearly. The more frequent the compounding the more interest you may end up paying. Because compound interest is added to accrued interest from the previous period, daily compounding will mean that each day that passes you pay interest on the accrued interest from the previous day. This is common with credit cards.
Try to get a lower interest rate
Because compound interest is a percentage that is calculated on the principal amount of your loan and accrued interest, having a lower interest rate can help you pay significantly less in interest. Consider negotiating a lower interest rate on your credit card for instance.
Avoid capitalizing interest
This is quite common with student loans. You can skip paying the interest on your loan when it’s due and let it build up. This means the unpaid interest will be added to the loan balance, increasing the overall amount you owe. This will lead to either having to pay higher monthly amounts or taking longer to repay the loan.
Pay extra whenever you can
Making more than the minimum monthly payment can not only help you pay off your debt faster but it will avoid you all the compound interest. Especially on credit cards, only making minimum monthly payments will lead to paying huge amounts in interest as it compounds daily. This leads to the last and final point.
Always pay off your credit card balance
Always make sure to pay off your credit card balance by the payment due date. There is usually a grace period from the end of a billing cycle to the payment due date. Paying off your balance within this period of time will help you avoid having to pay compound interest on the interest accrued on the previous period and of course also having to pay late fees. Remember that usually, credit card issuers compound interest on a daily basis which means that in no time your balance could grow exponentially if you just make minimum payments.