How Does a Compounding Interest Rate Work?
Compound interest acts like a snowball, turning a small loan into a large debt. Learn how the math works before you sign.
When reviewing a lawsuit funding contract, you might see the term "compounding interest." While it sounds like a standard financial term, in the world of legal funding, it can be dangerous to your bottom line.
Compound interest occurs when interest is added to the original amount borrowed (the principal), and then the interest rate is applied to that new, higher number the following month. It is essentially "interest on interest."
The Snowball Effect: A Real-World Example
Let’s look at how quickly this adds up. Imagine you borrow $1,000 with a 2% interest rate that compounds monthly.
- Month 1: You owe interest on the original $1,000.
Interest Cost: $20.00 - Month 2: You now owe interest on $1,020 (the original $1,000 + last month's $20).
Interest Cost: $20.40 - Month 3: You owe interest on $1,040.40.
Interest Cost: $20.81
It might seem like small change at first (just 40 cents extra in Month 2), but legal cases often drag on for years. This "snowball effect" picks up speed over time.
The One-Year Totals
At the end of the first year, you would owe $1,268.24—the initial $1,000 plus $268.24 in interest. If the case goes on for two or three years, that number grows exponentially, eating away at your final settlement.
Compounding vs. Simple Interest
This is why it is critical to look for companies that offer Simple Interest. With simple interest, the rate is only ever calculated on the original $1,000 you borrowed.
At Flash Legal Funding, we believe in transparency. We don't want you surprised by a balance that has spiraled out of control. Always check your agreement to see if the word "compounding" is hiding in the fine print.