COMPOUNDED INTEREST - Capitalized interest

"COMPOUNDED INTEREST - Capitalized interest" submitted by SchoolGrantsfor Editorial Team and last updated on Sunday 8th January 2012

Interest that is paid on both the principal balance of the loan and on any accrued (unpaid) interest. Capitalizing the interest on an unsubsidized Stafford loan is a form of compounding.

The interest being paid on the debt may be simple or compound. Simple interest is computed on the principal alone, whereas compound interest is computed on the principal and on any interest that has not been paid. Capitalized simple interest is an easy method of computing interest (often used in spreadsheets or with pocket calculators) but is not always fair for the lender and borrower. With this method, the same amount of interest is computed daily throughout the period and at the point of capitalization (compounding) the total interest generated is added to the principal. This balance becomes the new principal upon which interest is computed until the next capitalization.

The "com" in compound also means a bit more complicated. Compound interest results in interest being calculated not only on the original principal, but also interest on the accumulated interest. As a real estate agent working with real estate investing clients, if compound interest is a factor, it's important that you know how to calculate compound interest.

Capitalized interest, Compound interest and accrued interest?

Capitalized interest is unpaid, accrued interest that is added to the principal balance of your loan. It is also called "compound interest." When interest is capitalized, your total debt increases. It is very important to make interest payments on unsubsidized Federal Stafford Loans, even when you are not required to (e.g., when you are enrolled in school at least half time or during your grace period or authorized periods of deferment). By making interest payments, you can save yourself a considerable amount of money over a standard 10-year repayment period.

Deferred student loans are a good example of capitalized interest. When someone decides to defer a loan and not make any payments or not enough payments to cover interest, they end up paying interest on interest.

Compound interest generally refers to gains from investments that result from earning returns on previously earned returns. Capitalized interest refers to debt that compounds because you are paying interest on interest that you have already accrued but not yet paid. These are similar terms but used in different contexts.

Power of Compound Interest

Suppose student A says she’s going to save $100 a month for 10 years. Student B says he’s going to wait until he’s making more money and then he’ll save $100 a month for 20 years. Who will have saved more money? Student A contributes $12,000 but ends up with nearly $73,537. Student B contributes $24,000 and ends up with only $46,435. Below Shows the value of starting a savings plan early:

Student A - Age 25 - $100/Month - 10 Years - Contributes $12,000 = $73,537 at age 60

Student B - Age 40 - $100/Month - 20 Years - Contributes $24,000 = $46,435 at age 60

Savings growth calculated at 6% interest as shown for Compound Interest
Graph: Savings growth calculated at 6% interest as shown for Compound Interest
Here’s what compound interest looks like on a chart. This is as close to getting free money as possible. The message here is the earlier you start saving, the more your money grows. Graphically demonstrates the smaller contribution and the greater interest earned by Student A.

Savings Calculator

Savings Calculator enables students to see how saving today can grow in the future. For most people, creating a budget also means establishing a savings plan and savings goal. As a student or recent grad, the most important part of saving isn’t the amount but simply beginning the act of putting a little away each month, even if it is just $20. Putting your money to work for you as soon as possible will pay greater dividends in the long run. We’ll discuss how in a few slides. If you can afford it, put at least 10 percent of your income in savings each month. When it comes to investing, consider participating in your employer’s retirement plan. How many of you have a savings account? The importance of saving: How to do it and why it’s important to form the habit early?

Saving vs. Investing

Generally, we save up for short-term goals and invest for long-term goals. Short-term goals are goals you want to reach in five years or less or money you’ll need to access in an emergency. A down payment for a house or car would be considered a short-term goal – as would saving for a vacation. If you have long-term goals like funding your retirement or a child’s college education, then investing might make more sense. The reason for the less-than-five-years or greater-than-five-years timeline is because investing takes on more risk. If you’re saving to put a down payment on a house you may not want it in the stock market because you could lose 10 percent or more in value just before you need your money. When saving with a bank or credit union your money is insured and protected against losing value. In this presentation we are going to review your savings options.

Investing for long-term goals
Saving for short-term goals

Reduce Spending

Reducing your expenses on an already-tight budget may seem difficult, but even a small change can make a big impact without taking out the fun. Simply skipping a $4 coffee or bringing your lunch five days a week will save you nearly $1,000 a year. Even sticking to a shopping list will help you avoid impulse items that can increase your grocery bill. When buying clothes, stick to the basics and make minor repairs instead of replacing them. Shop for health and beauty aids at discount stores and clip coupons to save even more.

To reduce transportation costs, consider an economy or used car. Public transportation and carpooling are other options which can also save you money at the pump as well as at the auto repair shop and in auto insurance. When eating out, shopping or going to the movies, ask for student discounts. Also check your local newspaper for free events such as art gallery openings or receptions, craft fairs, farmer’s markets and concerts in the park. Look for a list of local venues that offer student discounts or free entertainment.
Food

Clothes

Transportation

Entertainment

Personal Care

Savings Options

If you have money to save, there are four main options at banks and credit unions: checking accounts, money market accounts, savings and CDs (Certificates of Deposit). Identify most common savings options. A checking account is a way that you can start accumulating money. It pays the lowest interest rate of all the options but allows the most flexibility for transactions. If you have $100 or more then you might want to look at a savings account. Savings accounts pay higher interest rates.

Banks and credit unions

Checking account

Money market account
Savings account

Certificate of deposit (CD)

Savings Larger Amounts

Once you have a larger amount of money to save, other options become available that pay you more interest. Money market accounts have higher interest rates than checking and savings, but money market accounts limit the number of times you can withdraw your money. If you don’t need your money for six months or longer then a CD (Certificate of deposit) is a good option. A CD pays you more interest the longer you agree to lock away your money. Most CDs require a minimum deposit (usually from $250 to $1,000), pay a high interest rate and they don’t allow any additions or withdrawals from the CD for the period of the CD (six months to five years). If you take your money out of a CD early you could be charged a penalty, usually equal to three months’ worth of interest.

Money market accounts
Certificate of deposit (CD)

Rule of 72

Imagine you have $1,000 and put it in a savings account or invested it. How long will it take to double? The rule of 72 tells how many years it will take to double your investment. Take 72 and divide it by the interest rate you’re earning. If you’re earning 8 percent then 72/8 is 9 years—your money will double in 9 years. The Rule of 72 (72/interest rate vs years needed for money to double) to estimate how their savings may grow. Below the graph and calculation illustrates how fast money will grow in savings or investment.
The Rule of 72 (72/interest rate vs years needed for money to double) to estimate how their savings may grow. This graph and calculation illustrates how fast money will grow in savings or investment.
Write down age, add nine years to it, then add another nine years and another nine years. Next to your age write $1,000. Now double that to $2,000 on the next line. Double the $2,000 to $4,000 and the $4,000 to $8,000 on the last line. This is how fast your money grows (assuming 8 percent growth each year):
Starting at age 25: $1,000
Age 34: $2,000
Age 43: $4,000
Age 52: $8,000
Age 61: $16,000
In 36 years, you’ll have 16 times the money you started with!

Savings Growth

Saving money isn’t exciting unless you can do something with it—like achieving your financial goals. We’ve seen how fast our money can grow, but what will the money do for us? Below showing that saving money every month can quickly grow to a substantial sum.

How To Succeed

Accumulating money is possible by starting off with a few good habits now. You’ve spent the past few years of your life preparing to earn a good income. Now’s the time to be sure you protect your future earnings by building a budget and planning to achieve your goals. This can be done by tracking expenses, finding ways to save that fit your lifestyle and then using your savings to pay down your student loan debt and start a savings program.

Special Note: This is intended to be a guide that introduces various financial planning topics and ways to overcome student’s capitalized debt. It is very important to make interest payments on unsubsidized Federal Stafford Loans, even when you are not required to (e.g., when you are enrolled in school at least half time or during your grace period or authorized periods of deferment). It is not intended to provide financial advice and it’s not meant to be professional guidance. Materials provided courtesy of EdFund.

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