# Calculating Interest (snooze) Except It Is Really Important and Here’s Why

Let me start by asking a question:

if you take a loan out for $1000 at 5% APR for 5 years, do you think you will **owe the lender $1000 plus $50 of interest for that 5 year period?**

**If you answer ‘YES’ you are not alone, but you are wrong**. APR stands for Annual Percentage Rate, which means 5% is applied to the outstanding balance each year. At the risk of boring you rigid, this is called the Compounding effect.

This is not a math lesson and I’m not going to explain the Compounding here, but suffice it to say **you owe a lot more than 5% of $1000 over the life of the loan** in the example above.

In our sample loan, you borrowed $1000 over 5 year with an APR of 5%. You will owe about $100 in interest over the life of the loan (5 yrs.). Why does this matter? Because **if you have credit card debt or you take out a consumer loan or HELOC to pay off credit card debt, you are going to pay A LOT more **than the interest rate multiplied by the principal loan amount over the life of the loan, which MAY change your mind about the loan.

Also, **it underscores the need to pay off debt as SOON as possible not just paying when you can**. If you take out a $500k mortgage over 30 years at 3.75%, all of which would be considered perfectly reasonable, you will end up paying… you might want to sit down… $333k in interest over the 30 year life of that loan. Not pocket change.

You can see you do NOT pay $3.75% of the $500k you took out as a mortgage (which would equal $18,750). **The compounding "pain" is generally worth it for a solid mortgage or student debt that allows you to earn more with your degree, but consumer loans should be a very last resort because of this hideous compounding effect. **

On the other hand, **compounding is your friend if you are a saver. If you save, especially when you are young**, over time your savings grow A LOT. If you save $2000/year at age 30 until age 50 and earn 5%, you will have about $69k, not $2000 * 20 years plus 5%, (incidentally, that’s $42k).

Do not be fooled by low APR rates. **Low APR rates are great, but remember another critical piece is how long it takes you to pay the loan back. Pay back quickly, save slowly over time**.