Compound Interest

Compound Interest

Compound interest is when interest is accrued not only on the principal of the loan, but also the already existing interest. 


What Is Compound Interest?

If you are planning to take a loan of any kind, you will likely encounter the terms “simple interest,” and “compound interest.” What are the differences between these two terms? How do they affect your loan?

Each loan is subject to one of two types of interest: simple and compound. Simple interest is based on a percentage of your loan’s principal. It is a fee that banks use to make money off of the loan transaction. Simple interest is calculated based only on your general loan amount, the interest rate, and the amount of time that you use to repay the loan. 

Compound interest is also formulated based on your account’s balance, the period of interest compounding, and the interest rate. While it may seem just like simple interest, it is very different because the interest “compounds.” That means that your interest can produce interest charges. Simple interest never charges any more than the interest on your principal, no matter how long you take to repay. By comparison, compound interest can be compounded on any frequency schedule, but it cannot be charged more often than on a monthly basis.

What Factors Influence Compound Interest?

Compound interest depends on several factors. The most important factors are the frequency of compounding, the interest rate, and your balance. Because compound interest can often be thought of as “interest on interest,” compounding frequency can make a big difference to your credit expenses. Even though compound interest cannot be charged more often than on a monthly basis, it can be compounded even daily. For example, if you have a monthly interest rate of 30% on a loan of $100 that is compounded daily, you will pay 1% on your current account balance each day. If you constantly have $100 on your account, that would mean your interest charge is about $1 per day.

The interest rate is important to determine compound interest. The higher the interest rate, the higher the interest charges will be. Also, to calculate compound interest, you need to sum up the total amount of principal and interest in the future, then subtract the present principal. You can use online calculators to help you with your calculations.

Is It Possible to Benefit from Compound Interest?

If you are saving money compound interest may be beneficial for you. You profit from more than just the funds that you saved; you also profit on the interest you are being paid as well. That means that you are effectively earning money based on already-earned amounts.

How Can I Tell If the Interest Is Compound?

If you are not sure whether your interest calculation is compound or simple, you can compare your annual percentage yield (APY) with your annual percentage rate (APR). Annual percentage rate differs from the annual percentage yield, as it includes fees your bank charges you for credit favors. If there is a sizable difference between these two numbers, chances are your interest is compound.

In general, loans are represented in APR, while investments will be in terms of APY, but this is not always the case.

Should I Take Compound Interest or Not?

If you are taking out a loan, carefully consider compound interest. Compounding can hurt your finances if you do not know how to deal with it.

If you are saving money, compound interest may benefit you. Of course, compound interest really only significantly benefits those who plan to leave their funds in the bank for a longer time span.

Compounding is repaying interest on interest. You not only get charged interest on your principal but also on your account balance. The effect of this type of calculation is based on the compounding frequency. A higher frequency will generally mean higher interest over time. You should be careful with compound interest. Compound interest is a double-edged sword; you can both hurt your finances with it or reap great profits.

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