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What is Compound Interest?

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Whenever a person takes out a loan, secures finance for a venture or refinances an asset, there is always a clause regarding the interest that the principal amount will accrue during the finance period. When the interest on the primary account is accrued and then added to the primary amount before the next interest is calculated, you are dealing with compound interest – In other words interest on interest. You are no longer working with just the primary amount and random interest. You’re dealing with an amount of money that is added to the primary fund and is then used as the basis of the next interest calculation.

Because one has to pay interest to borrow money, money depreciates over time, thus having different present value and future value.

Uses

This form of interest calculation is often used where people need long-term loans or large amounts of finance. It is one sure way for banks and other financial institutions to make more money than they give out. The compounded interest can also lead to longer terms of payment to accommodate the larger sums of money that have to be paid back. This is usually the case when you’re looking at mortgages and cash loans.

Dealing with Compounded Interest

Before you enter into any financial agreement, you need to be absolutely sure what kind of interest you are being charged. Static interest is better as you can predict how much the interest will be every month. If you’re charged compounded interest you will need to calculate how much you will need to pay so that you also pay part of your capital amount off and not just the interest on the money that you’re paying back. If you are only paying the interest, it can take you quite a while before you’ve paid back the loan.

Banks do very complicated calculations to include the compounded interest into the final amount payable. They will therefore tell you what the final amount is that is being financed. You then agree to pay the higher amount (which includes the interest) off over a set period of time (e.g. 2 years etc.). Should you default on the payments, new interest will be added to your account and a new amount for finance will be calculated.

Understanding how compounded interest works is one of the most important steps that you can take in securing a loan or any other type of finance. If you have the formulas that the financing companies use, you will also be able to calculate beforehand what your interest repayments will be when you borrow the money.

Should you try and get finance via the internet, it is possible to use the finance calculators that the companies make available on their websites to assist you with your calculations.

Conclusion

When dealing with compounded interest, you need to make sure that you pay as little interest as possible. Negotiate a favorable percentage and stick to the repayment agreements. The last thing that you want is for further interest to be charged on your already hefty financial burden.

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Meet the Author

Anthony Carter currently resides in Fife, Scotland with his wife Lisa, and their three wonderful children. As a senior editor for various publications, if he's not reading and writing, you would find him photographing and traveling to some of the most far-flung locations around the world.

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