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9.1 Responsible Borrowing

addition to being protected, the money you deposit in your savings account earns interest.
Think of that interest as rent on the money you put into the bank. After all, if the bank is going
to use your money to make loans, shouldn’t you be compensated for letting the bank use your
money? The bank makes money by paying you a smaller percentage than it charges its loan
customers. You might earn 0.5% on your savings, but a borrower on an auto loan would pay
2.4%, and the difference is the bank’s profit. That’s the beauty part, for both you and the bank.

Now, what about the beast of borrowing? When you borrow money from a lender, you agree
to pay back both the loan principal—the amount of the loan itself—and any interest that
has accrued over the loan term—the length or duration of the loan. Again, this interest is
effectively the rent you owe for being able to use someone else’s money. This is a scenario that
always benefits the lender, but it may be very costly to you depending on the loan you choose.

Let’s imagine that you are apartment hunting. Before signing any paperwork, you would come
to an agreement with the landlord about the length of the lease and the amount of rent you
pay. It’s unlikely that you would sign a 5-year lease for $1,500 per month when you only need
the apartment for a year and cannot afford to pay more than $800 in rent. Just as you wouldn’t
make this mistake with your housing, you can also avoid it when borrowing money.

Loans come in all shapes and sizes, and some options cost the borrower significantly more
money than others. The loan term and the way interest is calculated are the key variables in
any loan equation. We will explore various borrowing scenarios in the sections that follow.
For now, it is important to understand the difference between simple and compound inter-
est. Simple interest is calculated using the original principal balance and does not include
any interest that has accumulated on the loan. If you borrowed $1,000 and agreed to a 10%
simple annual interest rate, you would pay $100 (10% of $1,000) in interest each year. Com-
pound interest, on the other hand, is applied to the principal balance plus any interest that
has accrued. If the annual interest on your borrowed $1,000 were compound interest, then
you would pay $100 in interest only in
the first year. The interest for the sec- Table 9.1: Simple versus compound interest
ond year would be $110, which is 10%
Simple interest Compound interest*
of $1,100 (the original loan amount
plus the interest that has accrued so
Year 1 $1,100 $1,100
far). Other than auto loans, most loans
are calculated using compound inter- Year 2 $1,200 $1,210
est rates. Year 3 $1,300 $1,331

Year 4 $1,400 $1,464
Whether you are paying simple inter-
est or compound interest affects how Year 5 $1,500 $1,611
much you pay in the long run. With
Year 6 $1,600 $1,772
a simple annual interest rate over
10 years, you would pay $1,000 in Year 7 $1,700 $1,959
interest on a loan of $1,000. With a
Year 8 $1,800 $2,145
10% compound annual interest rate,
however, you would pay $1,594 in Year 9 $1,900 $2,358
interest on a loan of $1,000 over the
Year 10 $2,000 $2,594
same time period. Table 9.1 provides
a comparison. *Rounded up to the nearest dollar.

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