Tyler Gross

Prof. Suetorsak
FIN 1380-001
17 November 2014

Gross 1

Rolling Loaded Dice: The Potential Cost of Walking into High-Interest Loans
Too often, people walk into investments without looking beyond the price. I was lucky to
be able to take out an interest-free loan at my work. I borrowed 600 dollars and paid off $150 off
every bi-weekly check for 2 months. In typical financing, this is unheard of. When youre
signing a contract, having knowledge of interest becomes your bargaining power- your ability to
roll the dice, if you will. Therefore, it may be of some value to you to understand why this
happens. The first thing you need to know is that there is a difference between simple interest
and compounded interest, and then we can talk about the benefits of paying loans off quickly.
First off, simple interest is an easy concept. You can calculate it using this easy-to-use
formula: I=PRT or Interest equals Principal times Rate times how long the investment has been
gaining interest (i.e., Time). Time begins when you invest a Principal. Whether it be a savings
account or a loan, the more time the principal is left untouched the greater the interest. Time is
always based annually because the rate is always annual.
The difference between simple interest and compounded interest is the number of times
interest is charged by the lender per year. All simple interest investments are compounded once a
year, but compounding an interest rate means you will have to pay semiannually, quarterly or
even daily depending on how often the interest is compounded. The Rate in simple interest
formula is divided to form the compounded Rate, and Periods takes over the amount of time
based on how many times the principal is compounded in a year.
Lets put it into simpler terms. Lets say my boss had decided to give me a loan with an
8% interest rate compounded annually. In this scenario, I decide to pay it off in 6 months. Well
plug in the values now: P= $600, R= 8% and Time = .5 (for half a year). This gives me 24
dollars in interest and therefore the $24 more that Ill have to pay off this year on top of my
principal. . Simple interest payments base the payment schedule off of the aforementioned
formula. So the payment schedule would look like this: (Notice that the amount paid to interest
stays the same per month.)
Payment (NOT BASED ON
COMPOUND)
00
104
104
104
104
104
104

Interest

New Principal

00
4
4
4
4
4
4

600
500
400
300
200
100
100

Gross 2

Lets make sure everything looks correct. The number of periods that interest compounds is 1,
for one year. Im paying my loan in less than the time allotted, so there is no need to configure
for periods or adjusted rates. Based on this, Ive decided to pay off my debt in months at 104
payments. Easily do-able.
Many times when you take out a loan, your payment schedule will already be worked out
for you. And not only that- the lender will compound your interest. Heres what my loan interest
schedule would have looked like compounded semiannually, paid off in a year:
Principal
Rate= 8/2=4
P*R= Interest
Beginning of Period
End of Period

1st half of year

600
0.04
24
600
624

2nd half of year

624
0.04
24.96
624
648.96

Whoa. How did my interest more than double? The key to understanding Compounded Interest
is to know that the odds are working in the lenders favor. In this scenario, not by much. (By a
factor of 96 cents, in comparison to simple interest terms.) But how about some of the other
scenarios in which this loan could be paid off (Interest bolded):
1 year, compounded semiannually
2 years, compounded semiannually
2 years, compounded quarterly
5 years, compounded monthly (highly unlikely)

648.96-P=
701.94-P=
703.02-P=
893.91-P=

48.96
101.94
103.02
293.91

To be a wise consumer, take into consideration how many periods will occur in a year (to
find adjusted rate) and the number of periods in a loan (Number or Period). You may be asking
yourself why dont we all just pay off our loans quickly to avoid paying high amounts of
interest? There are two reasons: 1.) People suck at making payments. Period. (no pun intended)
And 2.) Most contracts have restrictions against it. Lenders make money when people pay
interest, and if lenders dont make money (in the event that you pay off your loan quickly) then
lenders go out of business and nobody benefits.
The fact of the matter is this: youre playing a tough game if you take out a loan.. Just
know that you always pay on top of what youre borrowing. Be sure to look out for high interest
rates, heavily compounded interest, long term investments (every year costs more than the last)
and fixed, rigid schedules; if you make a deal with all of these elements plus adjustable interest
rates, you might as well be rolling someone elses loaded dice.