Interest is the fee you pay for using someone else's money. That part is simple. What is not simple, and what catches almost everybody, is how fast it grows when it is charged on itself.
Start with a number
Say you borrow ten thousand rupees at two percent a month.
Two percent of ten thousand is two hundred. So the first month costs two hundred rupees. That sounds manageable, and it is why the monthly figure is the one people are quoted.
But if you do not repay, the second month is not charged on ten thousand. It is charged on ten thousand two hundred. Then on ten thousand four hundred and four. The amount you owe is now growing, and the interest is growing with it.
After twelve months of that, ten thousand rupees has become about twelve thousand six hundred and eighty. You have paid roughly twenty seven percent, not twenty four, and certainly not the two percent that was in the conversation.
Now make the rate worse
Two percent a month is a reasonable rate. Informal lenders often charge five or ten percent a month, and the arithmetic stops being gentle very quickly.
The same ten thousand rupees at ten percent a month, left for a year, becomes a little over thirty one thousand. The debt has tripled. Nothing unusual happened. Nobody was cheated. That is simply what the number does when it is allowed to run.
This is the single piece of arithmetic we most want students to carry home, because it is the one that costs families the most when they do not have it.
The same force, pointing the other way
Compounding is not a trick played on borrowers. It is just how money grows over time, and when you are the one saving, it works for you instead.
Five hundred rupees a month, kept somewhere earning around seven percent a year, is about sixty six thousand after ten years. You will have put in sixty thousand. The rest arrived because the interest started earning interest.
It is slow. It is genuinely unexciting for the first few years. It is also the only version of this force that is on your side.
What to actually do about it
- Ask for the annual figure, not the monthly one. If a lender will only discuss the monthly rate, that is information about the lender.
- Ask for the total repayment amount in rupees. Percentages are easy to talk around. A total is not.
- Pay off high interest debt before you save, unless you have nothing set aside at all. Debt at twenty seven percent costs more than savings at seven percent earns.
- If you must borrow, borrow from a bank or a registered lender before an informal one. The rate difference is not small.