Cumulative interest is the total interest payments made on a loan over a period of time. When you borrow money, you repay both the amount you borrowed as well as the interest that the financial institution charges through regular payments.
Many common types of loans like mortgages, auto loans, and personal loans are amortized. When you first begin making payment on an amortized loan, most of the money will go toward interest payments. Over time, your interest payments will decrease and more of your monthly payment is applied toward the principal.
Cumulative interest is often used to determine which loan is the most affordable. So, understanding how cumulative interest works, particularly with amortized loans, will help you make better decisions when choosing a loan.
Definition and Example of Cumulative Interest
Cumulative interest is the total amount of interest you pay on a loan from your first payment to your last. It can vary based on both the length of the loan and the interest rate on the loan.
With amortized loans, your payments will stay consistent over the life of the loan, but the interest you pay each month will gradually decrease. In the beginning, the majority of your loan payments will be applied toward interest, while at the end most of your payment will go toward the principal.
So, because your interest rate payments change, calculating your cumulative interest on amortized loans is more complicated than just multiplying an interest rate payment by the number of payments you will make.
Many people will compare the cumulative interest for different loans on an amortization table to see which loan is the most affordable. When comparing loans, be sure to also factor in any other fees your lender might charge.
How Cumulative Interest Works
Cumulative interest works simply by tallying the total amount you pay in interest on a loan. However, lenders calculate interest payments in different ways. Once you learn 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 say you bought a $380,000 home. You took out a 30-year, fixed-rate mortgage for $304,000 with a 3.5% interest rate.
Let’s say your monthly payments for principal and interest was $1,365.10, and it did not include other costs like property taxes and homeowners insurance. The first payment may put $478.43 toward principal and $886.67 toward principal. Over time, the payment toward your principal would increase as your payment toward your interest would decrease.
So, by your last payment, you may be putting $1,318.21 toward principal and $46.88 toward interest.
The cumulative interest would be the total of each payment you made toward interest for the life of the loan. You can use a mortgage calculator that can calculate the individual interest payments to help you figure out that total. So, in this example, that may mean you pay a total of $187,434.51 in cumulative interest over the 30 years.
Knowing the cumulative interest, you can compare it with the cumulative interest you would pay on another type of loan, perhaps for one with a shorter term or a different interest rate.
You can see that, with this loan, you would be repaying a total of $491,434.51.
- $304,000 + $187,434.51 = $491,434.51
Reviewing the cumulative interest is a helpful way to determine how much your loan will cost. But it doesn’t account for additional fees your lender may charge, like origination fees or prepayment penalties. And, in the case of mortgages, cumulative interest doesn’t include the closing costs on your mortgage.
Compound Interest vs. Simple Interest
To calculate your cumulative interest, you’ll need to know how your individual interest payments are calculated, namely whether they are simple or compound. SImple interest, which is used for loans like personal loans, auto loans, and mortgages, is just applied to the principal amount.
With compound interest, the interest you owe is added to the principal. This means you’re actually paying interest on your interest, causing your cumulative interest to grow at a faster rate. Credit card interest typically compounds daily.
Compound interest can work in your favor if you are the one earning the interest, such as through a savings or investment account.
The terms cumulative interest and compound interest are sometimes used interchangeably, but they aren’t the same thing. Cumulative interest is the total interest you pay over time. Compound interest is a way the interest is calculated, which, again, is by applying to both the principal and past interest.
- Cumulative interest is the total amount of interest you pay over the life of the loan.
- Understanding how cumulative interest works can help you compare loan offers from different lenders.
- On an amortizing loan, your interest payments will decrease over time and your principal payments will increase, so your interest payments will be different each month.
- Amortizing loans include loans like mortgages, auto loans, and personal loans using simple interest calculations.
- Compound interest happens when interest is applied to both principal and past interest, which causes interest payments to grow.