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Drowning in Debt
In some cases it is possible to “drown in debt”; often this phrase refers to a situation where the interest is capitalizing faster than the borrower can pay it off. Let’s take a look at how this can happen:
Assume that Robert has taken out a $10,000 loan at 9% APR. At the end of his first month, his monthly interest accumulates:
$10,000 (the balance owed) x .09 (the annual interest rate) = $900 (annual interest)
$900 (annual interest) / 12 = $75 (monthly interest)
Capitalize the interest:
$10,000 (balance owed) + $75 (monthly interest) = $10,075.00 (new balance owed)
Next month, Robert makes a payment of $40 on his loan.
$10,075 (balance owed) - $40 (Robert’s payment) = $10,035 (new balance owed)
At the end of month 2, the interest is capitalized:
$10,035 x .09 = 903.15 (annual interest)
903.15 / 12 = $75.26 (monthly interest)
$10,035 (balance owed) + $75.26 (monthly interest) = $10,110.26 (New balance owed)
As you can see, Robert is in somewhat of a dangerous position here; if he continues to only make $40.00 payments each month, the balance owed is going to continue to increase and he will never pay off this loan. The worst part is that it only gets more difficult to pay it back over time because the interest builds on itself and accumulates faster and faster with each passing month. It is for this reason that care should be taken when using credit, as it is quite possible to end up in a situation with no way to pay off your debts.