The compounding effect is often overlooked by people because it is hard to calculate simply. This may sound strange but it is true, we often like to work out figures in our head but compounding is something which is not so easy to get your head around.
Imagine the following, you are sitting in an empty swimming pool which is a little higher than you. A drop of water enters the pool and the amount of water doubles every second. So the single drop turns to two and the two drops turns to four drops a second later. Things would seem to move slowly for a time but in the last second the pool would go from being half empty to being completely full. This is an example of the effects of compounding and the way it can lead to a little wow at the end for a human.
Of course this example is a little extreme when compared to a home loan over 30 years at lets say an interest rate of 6%. But the fundamentals are the same. You see every dollar that pay of your home loan means there will another six cents per year available to knock off another six cents in principle every year. Which in turn saves you more interest.
OK so what does this mean for you? Simply for the example above every $1,000 you borrow will cost you $2,157 in repayments over 30 years. Sounds depressing I know but the good news is that the compounding effect also works on extra payments. Surprisingly an extra $5 per week in repayments can save you almost $14,000 in interest for the example above. That’s a pretty good return on your investment, $5 extra per week is $7,800 over 30 years. That’s almost like giving someone $7,800 and having them return $14,000 back to you.
Another way to look at this is that for every $10,000 you can save of the purchase price of your home purchase there will be around another $10,000 worth of interest you will save in 30 years as well. That’s another $20,000 in additional payments towards the loan balance!