Compound Interest

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Author: Internal 

Editor: True Blue Loan products DO NOT use Compound Interest. This is a general information article only.

Be it the interest rate of a loan or an investment stake if interest that works on your favor can turn soil to gold; if the flow is reversed, so is the reward. That is why it is important to know how interest works. Depending on how well you can take advantage of a situation benefits overall wealth.

There are two well-known ways of calculating interest; however we will not focus our “interest” on the simple one today. This is an assessment of Compound Interest, and why “Compound interest is the eighth wonder of the world. He, who understands it, earns it … he who doesn’t… pays it.” As stated by world renowned scientist and mathematical mastermind Albert Einstein.

Compound  interest, in short, is an accumulation of interest on unpaid interest along with original principal sum. Compound interest is something most people have dealt with when it comes to investments, loans or savings. Is it important to know how complex interest works? Yes, absolutely. So when does it turn in your favour and when does it turn against you? Lets take a serious look into that matter.

For the most part, compound interest is what most of us deal with in the investments and loans that we make. Having some sort of understanding of the nuances of compound interest can truly help in building long-term wealth.

The History of Compound Interest

This is a very controversial subject matter and has been that way throughout history. There are laws in Christianity and Islam that forbid the compound interest practice among money lenders. It has been seen as a ‘sin’. Ginormous empires like the Romans had passed laws to cuts off the practice of charging compound interest on loans, and so did many other cultures. But despite all the attempts taken to stop the practice, it still lives at large and is legal too in most of the countries.

How to turn Compound Interest in your favor:

If you are investing a large principal for a long time, compound interest could yield substantial amount of profit down the line. It also depends on the period of calculation. The period of calculation is the time when the interest payout is added to your capital. Periods are: monthly, quarterly and annually. Needless to say, monthly period computing yields most in all three and yearly yields the least profit. The exponential built-up works in your favor earning you money from the interest that you have earned.

Take a short example:

Suppose you invest £20,000 for 20 years on 5% annual compound interest rate. This will yield you £53,065.95 at the end of said 20 years. So the profit to be noted here is £33,065.95 that is almost one and a half times your capital.

Now do the same calculation for simple interest, and it yields you a measly £40,000; the profit is same as your capital.

Editor: The calculations in this example are for illustrative purposes and have not been checked for accuracy. No reliance should be placed on them.

The same calculation would have yielded even higher profit for compound interest had the calculation period been quarterly or monthly. There are a few firms and banks in UK who offer investment opportunities at compound interest. The rules, regulations and guidelines vary up to some extent, but a compound interest will definitely give you a large profit margin. So the lesson to be learned here is, no matter how you are investing your money in compound interest, be it a savings account for short term or long term investments, it is going to work out in your favor with a substantial turnaround value.

When Compound Interest turns against you:

When it comes to compound interest, whoever is at the receiving end is in investor’s paradise. The other end? Not so much. Let’s talk about loans. There will be people who have a time in their life when they will be in need of money. In the dire situation, the decision-making logic might not go through your brain membrane about how much the compound interest can bite you back in the long run. If that is the only way available to get a long term loan, people are advised not to do so unless there is substantial potential gain from the money they are borrowing.

The prime reason for the loan’s exponential increase is due to the compound interest factor, and it is extremely likely to get out of hand. With time, more and more interest is added to the main loan, causing you recurring debt. It would become a vicious cycle. The most frequent example of this can be seen in credit card bills. The ideal solution would be to pay off the debt as soon as possible so that it does not get out of hand. So even if paying a minimum amount might seem like an easy solution, you would end up paying substantially more than the amount you actually borrowed.

It is not unavoidable in all cases. In case you don’t have any option, do a simple thing to counter the effect of compound interest, which is paying off a little extra than the minimum amount, if you can’t pay off totally at once. Even if you pay just a little more than you are required to put on your credit card, you can make tremendous savings.

Point to be remembered:

Try not to have compound interest as your enemy. It is not an easy battle and the enemy has all the advantages. But if you are working compound interest in your favor, we have a tip or two for you. Stay on top of all your loan payments and try to pay off as soon as possible. Always pay a little extra to end the cycle sooner and cut the loss shorter. If you can keep control on your finances, you can gain a surmountable amount of profit from compound interest over the years. So find banks and firms and start investing.