What Is Interest-Bearing Debt?

What Is Interest-Bearing Debt?
••• Photodisc/Photodisc/Getty Images

Interest-bearing debt is any debt that requires the payment of interest at a specified interest rate by the borrower. Examples include bank loans, personal loans, auto loans and student loans.

The cost of having interest-bearing debt is typically higher when you are young, but the interest payments can decrease as you get older if you establish a good credit record and raise your credit scores. The debt is created when you borrow money from a lender, which adds interest onto the unpaid balance until you pay off the total amount of money you were lent.

The interest rate applied by the financial institutions that advance the loan can add significant costs to a loan that borrowers have to pay off.

Interest-Bearing Student Loans

For many young people, the first exposure to interest-bearing debt that undergoes amortization occurs if they take out student loans to help pay for college.

For example, according to Federal Student Aid, the Federal Direct Subsidized Loan program for undergraduates has applied a ‌4.99 percent‌ interest charge on the money that is being lent to students in the year 2022/2023. The same also applies to Unsubsidized Loans.

However, during the payment pause period, your Direct Subsidized and Unsubsidized loans will attract an interest charge at a ‌0 percent‌ rate. But once the pause ends, the stated fixed interest rate will apply to the loan amount as long as it is paid off as agreed and does not go into default.

How to Determine Interest

The interest on a federal subsidized loan is applied using the daily simple 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.

Imagine, for example, an interest rate on a loan of 3.86 percent. The daily rate would be 3.86 percent divided by 365, which is 0.00010575.

Now, suppose that 30 days have passed since the last payment, and the principal balance is $10,000. The formula for finding the interest charge for the month would be 30 x 0.00010575, which equals 0.0031725. That number is then multiplied by $10,000 to obtain the interest charge for 30 days, which is $31.73.

Calculating Monthly Payments

The standard federal student loan repayment plan has a loan term of 10 years or 120 months, during which time you are expected to pay your debt in installments. However, many people take longer to pay off their debts even on such a plan. Others will opt for a different type of loan that allows for a longer repayment period to improve their cash flow.

For example, if you opt for Direct Consolidation Loans, Federal Student Aid says the loan repayment period of time varies from ‌10 to 30 years‌. However, you can shorten your repayment period by using any extra money you earn to make extra payments.

Typically, 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. For example, the total interest charged on a loan whose principal amount is $10,000 at 3.86 percent interest for 10 years, you will have to pay interest of $3,860.

The first monthly payment (consisting of principal and interest) 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. That is why car loans, mortgages and credit cards are common loan products that charge interest on money that is borrowed.