Why borrowers pay interest on interest?

Certainly, banks do not charge interest on interest! A bank charges interest on the principal outstanding during the interest calculation period. When that interest is debited (raised) and invoiced to the client but not paid at that time, then this unpaid interest becomes part of the principal outstanding in the next interest period.

The interest on interest question is simpler in terms of effective interest rate calculations. The effective interest rate is designed as an annualized index of the cost of borrowing that can easily be compared across different interest calculation and principal amortization arrangements.

So, how much does it cost to have use of – let’s say - 100 euro for one year?

If interest and principal are paid only once at the end of 12 months in cash, then the calculation is trivial. The effective annual rate is the nominal rate applied to the balance.

Many micro, consumer and small SME loans however, are amortizing and pay interest monthly (or quarterly). Therefore, if you borrowed 100 euro on 01Jan and on 01Feb the bank asking you to pay an interest and principal installment, then in order to maintain use of a full 100 euro for a year, you have to re-borrow the principal and interest just paid. That way, you will end up paying new interest on the interest that you just paid and re-borrowed.

Of course this is theoretical, because most people will not re-borrow on the same day and for exactly that amount. It is just an assumption that makes various loan schedules comparable in terms of cost. However, the reality in working capital micro, consumer and small SME finance is not far off from this theoretical assumption. Most borrowers have a permanent revolving and growing working capital requirement, so they borrow a little more than they need at first, then they pay a few installments into the loan and finally they do re-borrow in order to get back up to their working capital requirement.

Thus indeed, borrowers end up paying interest on interest!

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