Cumulative interest refers to the sum of all interest charges paid, or would be paid, on a debt over a particular period of time.
This helps a borrower see how much he or she has paid for interest expense for a loan from the moment the funds were drawn to the current moment, at a point in future, or at the end of the lifespan of the loan.
For example, a $10,000 loan with a 2% flat annual rate on the original loan amount that has run for 2 years would currently have a cumulative interest of $200, have a cumulative interest of $500 after 5 years. And assuming that it’s a 10 year loan, have a cumulative interest of $1,000 over the life of the loan.
Cumulative interest in use
For a typical home loan that is fully amortizing, the cumulative interest would rise with each installment payment at a decreasing rate.
This means that the actual dollar amount that is added to the total cumulative interest on each following payment would decrease.
For example, the current month might have $100 added to the total. And the next month would be $99, and then $98 the following month. So while interest charges are still regularly added to the total interest, the amount would decrease with each scheduled payment.
This occurrence is due to the mechanism of such loans that requires a repayment amount that remains the same, but the portion that goes towards repaying the principle increases with each payment.
Because cumulative interest is expressed in dollars rather than a percentage, it is easier for a person to see how much he or she would be paying exactly should a term loan be taken up.
While the interest of credit facilities expressed in percentage can help one do comparison between similar products easily, seeing real dollars can have a deeper personal impact.
Seeing the total interest that would be paid on a loan in real dollars can often open the eyes of a borrower to what he or she is really signing up for. This is in contrast with a percentage of let’s say 5%.
Rather than percentages, real numbers also helps one analyze whether loan repayment obligations would be above what he or she can afford.
However, borrower must not forget that cumulative interest is not a measure of the cost of financing.
This is because other expenses for credit facilities such as upfront costs, annual fees, late payment penalties, the time value of money, etc, will have to be accounted for when calculating the costs of credit.
Cumulative interest and compound interest
When discussions surrounding cumulative interest come about, the subject of compound interest usually makes it’s way into the conversation.
This is even though they are fundamentally not the same.
The former is a summation of interest, while the latter is a calculation of interest.
One of the reason why they often pop up together in discussions is that cumulative fixed deposits enable depositors to have their money work for them. And is therefore, highly sought upon by consumer savers.
Cumulative fixed deposits enable savers to earn interest on the interest earned.
This means that for a fixed deposit that earns 3% interest annually on $20,000, the account would earn $600 at the end of the first year. And at the end of the second year, it would earn $618 at the base amount would have increased to $20,600 at the start of the second year.
This interest earned on interest is how compounding interest calculations work.
And even though the increase of $18 earned can seem like a small amount, the increase can be very substantial over the long term of 10 or 20 years, and more.
Non-cumulative fixed deposits don’t have such mechanisms built into them.
These types of savings account pay out interest earned by the depositor on a regular basis. Usually in the form of a cheque.
This prevents the interest earned from being automatically added to the original deposit. Thus, preventing consumers from compounding their interest earned.
Banks would also not allow depositors to manually add those funds into the FD account. And would advise customers to open a new account for time deposits with a minimum deposit to be eligible for attractive interest rates.
So if the minimum deposit amount is set at $10,000, an individual with only $15,000 of cash would only be able to open one fixed deposit account. He would also not be able to use the interest earned to earn more interest as he would be unable to put that money into another FD.
This prevents depositors from taking advantage of compound interest effects.