Definition and Example of Cumulative Interest
Cumulative interest is the total amount of interest you pay on a loan over a period of time. Understanding how cumulative interest works can help you compare loan offers from different lenders. In a declining balance loan, your interest payments will decrease over time while your principal payments will increase, so your interest payments will vary each month. Declining balance loans include loans such as mortgages, auto loans, and personal loans using simple interest calculations. Compound interest occurs when interest is applied to both the principal and the previous interest, resulting in increased interest payments.
How Cumulative Interest Works
Cumulative interest works simply by the total amount you pay as interest on the loan. However, lenders calculate interest payments in different ways. Once you know how much you will pay each month in interest, you can calculate your cumulative interest.
To illustrate how cumulative interest works with a mortgage, let’s assume you purchased a home worth $380,000. You took out a fixed-rate loan for 30 years for $304,000 at an interest rate of 3.5%. Let’s say your monthly payments for principal and interest were $1,365.10, excluding other costs such as property taxes and homeowner’s insurance. Your first payment might allocate $478.43 to principal and $886.67 to interest. Over time, the payment toward principal will increase while the payment toward interest will decrease.
So, in your last payment, you might allocate $1,318.21 to principal and $46.88 to interest. The cumulative interest would be the sum of all the payments you made towards interest over the loan period. You can use a mortgage calculator that can calculate individual interest payments to help you determine this total. Thus, in this example, you might pay a total of $187,434.51 as cumulative interest over 30 years.
By knowing the cumulative interest, you can compare it with the cumulative interest you will pay on another type of loan, perhaps for a shorter term or a different interest rate.
You can see that with this loan, you will repay a total of $491,434.51. $304,000 + $187,434.51 = $491,434.51
Reviewing cumulative interest is a useful way to determine the cost of your loan. However, it does not take into account any additional fees that your lender may charge, such as origination fees or early repayment fees. In the case of mortgages, cumulative interest does not include closing costs on your mortgage.
Compound Interest vs. Simple Interest
To calculate your cumulative interest, you will need to know how to calculate your individual interest payments, specifically whether they are simple or compound. Simple interest, which is used for loans like personal loans, auto loans, and mortgages, is applied only to the principal.
With compound interest, the interest accrued is added to the principal. This means you are actually paying interest on your interest, resulting in cumulative interest increasing at a faster rate. Credit card interest typically compounds daily.
Compound interest can work in your favor if you are the one earning interest, such as through a savings account or investment.
The terms cumulative interest and compound interest are sometimes used interchangeably, but they are not the same thing. Cumulative interest is the total interest you pay over time. Compound interest is a method of calculating interest, which is done by applying it to both the principal and the previous interest.
Source: https://www.thebalancemoney.com/what-is-cumulative-interest-5209012
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