The cost of having interest-bearing debt is typically higher when you are young and can decrease as you get older if you establish a good credit record. The debt is created when you borrow money from a lender, which adds interest onto the unpaid balance until you pay off the loan. The interest rate applied can add significant costs to a loan.
For many young people, the first exposure to interest-bearing debt can occur if they take out student loans to help pay for college. For instance, the Federal Direct Subsidized Loan program for undergraduates has applied a 3.86 percent interest charge on the money that is being lent to students between July 1, 2013, and June 30, 2014. The rate will apply to the loan amount as long as it is paid off as agreed and does not go into default.
The interest on a federal subsidized loan is applied using the simple daily interest formula. The outstanding balance on the loan is multiplied by the number of days since the last payment was processed and multiplied again by the interest rate factor. The interest rate factor is determined by dividing the interest rate charged by the number of days in a year – in this scenario, this would be 3.86 percent divided by 365. For example, if 30 days have passed since the last payment and the loan amount is $10,000, then the formula would be 30 x $10,000, which equals $30,000. The $30,000 is then multiplied by an interest rate factor of 0.0001057.
A student is allowed to make up to 120 monthly payments to pay off the loan. The monthly payment amounts are determined by combining the interest rate charged for each month with the percentage of the outstanding balance that will be paid. The total interest charged on a $10,000 loan at 3.86 percent interest for 10 years is $3,860. The first monthly payment would be $100.58. The principal loan portion would be $68.41, and the interest portion would be 32.17. The interest charged will decrease a little bit each month as the outstanding principal is paid down until the entire balance is paid off.
Why Charge Interest?
Interest-bearing loans are made by lenders to earn money from the funds they lend to people and businesses. The cost to borrow allows lenders to stay in business, pay their bills and employees, and earn a profit. Car loans, mortgages and credit cards are common loan products that charge interest on money that is borrowed.
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