How Interest Supercharges the Cost of Debt: A Simple Guide

Imagine you want to borrow something from a friend, like their bicycle. You ask to borrow it for a week. Your friend agrees, but asks you to give them a small gift when you return it, maybe a box of chocolates. That little gift is kind of like interest when you borrow money.

When you borrow money, whether it’s for a car, a house, or just using a credit card, the lender (like a bank or credit card company) is essentially letting you use their money for a period of time. Just like your friend might want a little something extra for letting you use their bike, lenders want something extra for letting you use their money. This “something extra” is called interest.

Interest is essentially the cost of borrowing money. It’s a percentage charged by the lender on top of the original amount you borrowed, which is called the principal. Think of it as a fee for renting money.

Let’s break down how interest makes debt more expensive. Imagine you borrow $1,000 from a bank to buy a new washing machine. The bank says they will charge you 10% interest per year. This 10% is the interest rate.

That 10% interest isn’t just a one-time fee. It’s usually calculated and added to your debt over time, often monthly. So, in our washing machine example, if you only paid back the original $1,000 after a year, you would also owe 10% of that $1,000 as interest. That’s $100 in interest (10% of $1,000 is $100). So, you wouldn’t just pay back $1,000, you’d pay back $1,000 + $100 = $1,100. That extra $100 is the cost of borrowing that money for a year.

Now, what if you take longer to pay back the loan? Let’s say you only make small payments each month. Interest is usually calculated on the outstanding balance – the amount you still owe. So, if you only pay back a little bit each month, you’ll still owe interest on the remaining balance. This is where things can get more expensive over time.

Let’s illustrate with a simpler example. Imagine you borrow $100 and the interest rate is 20% per year.

• Scenario 1: You pay it back quickly. If you pay back the $100 in one month, you might only owe a small fraction of that 20% annual interest. The interest for one month would be roughly 20% divided by 12 months, which is about 1.67% per month. So, you’d owe roughly $100 + (1.67% of $100) = $100 + $1.67 = $101.67. Not too bad.

• Scenario 2: You take a long time to pay it back. But what if you only pay a very small amount each month? Interest keeps adding up on the remaining balance. If you only paid back $10 per month, after the first month, you’d still owe around $90 plus interest on that $90. And the next month, interest would be calculated on whatever is still left, and so on. Over time, because you are taking longer to pay it off, more and more interest accumulates. You end up paying back much more than the original $100 you borrowed.

This is the core reason why interest makes debt more expensive. It’s not just about paying back the original amount you borrowed. You’re also paying a fee – interest – for the privilege of borrowing that money. The longer you take to repay the debt, and the higher the interest rate, the more you will pay in interest, and thus, the more expensive the debt becomes overall.

Think of it like this: interest is like a snowball rolling downhill. The longer it rolls (the longer you take to pay off debt), the bigger it gets (the more interest accumulates), and the more expensive it becomes in the end. That’s why understanding interest is so important for managing debt effectively. Paying off debt quickly, and choosing loans with lower interest rates, can save you a significant amount of money in the long run.