What is compound interest?
More than once we have heard the word “interest” mentioned, and we tend to pay more attention to it when it comes to our finances. Interest is the price that must be paid for the use of a certain amount of money, if we are the ones who have made a loan, this amount will be in our favor and if, on the contrary, we are the ones who are assuming a new debt, this interest represents the additional amount that we will have to pay.
This last case is the most common, as companies or as persons we find ourselves in need of extra money to cover an expense, finance a project or make an investment. It is there, where the word interest acquires greater relevance and it becomes very important to evaluate what are the conditions in which the payment of this amount will be imposed on us.
Today, from our mission as a responsible financial institution, we want to help you learn a little more about this topic. In this article, we will focus on compound interest and why it is important to understand what it is before accepting a loan that could seriously harm our finances.
What is compound interest?
As mentioned previously, interest is the additional amount that a person assumes when acquiring a debt, this is usually a percentage of the value of the loan, that is to say, a percentage of the initial capital; However, over time this interest accumulates and transforms the principal amount into a higher one after each payment period, which is usually monthly for most financial institutions.
In other words, acquiring a debt with compound interest implies that each month that percentage will be added to the capital making this debt increasingly larger, since the new interest to be paid will be calculated with respect to this new amount, and not the original amount of the loan, this system in which the interest is capitalized in each payment period, is assigned the compound interest name. In this way it differs from simple interest, which is calculated based on the initial capital.
If you want to know in detail the differences between the two interest rates, have a look our article What is the difference between simple and compound interest?.
What factors should we take into account to evaluate compound interest?
Just as we evaluate our finances and ability to pay when acquiring a loan, it will be just as important to keep in mind the two factors or elements that will allow us to have a clear idea of how the compound interest of the loan we are assuming will be calculated.
– Number of period or term: This element refers to the time in which the loan is assumed, commonly measured in number of months.
– The interest rate:The percentage that represents the amount of interest.
Taking knowledge of these two elements, it will be easy to calculate the interest that we will have to pay each month for this debt and determine whether or not it is convenient for us to acquire it.
Is it a good idea to accept compound interest debt?
Determining whether or not the compound interest that will be assigned to a loan is convenient for us, will be the key to confirm whether or not we will be able to get out of this debt.
On many occasions, when there are no other options to finance ourselves and acquire a loan that allows us to achieve our goals, get out of other debts or solving problems, we will only have to assume the payment of that extra amount, since the interest rate is imposed by the person making the loan and is not usually negotiated.
Therefore, if we are able to evaluate different alternatives or financial entities to grant us this facility, it will be essential that we verify which of them allows us to acquire a lower interest rate or better conditions paid, since each one has the ability to offer different alternatives that are more convenient according to our profile.
On the other hand, if we find ourselves from the position of the lender, that is, we are the ones who are going to give that money to someone else as a loan or as an intermediary to manage it in exchange for receiving future returns, we will be interested in this return being as high as possible to benefit from the fact that another person or entity uses our money, in instead of us being the ones using it at that time.<
In this case, compound interest has a beneficial role since the amount we will receive would be increasing, because as explained above, each month the interest will be capitalized causing this debt to increase. This is also explained in depth when we talk about the best investments with compound interest.
Here is an example with which, in a practical way, we can better understand how compound interest works.
If we want to calculate the interest of 30,000 euros for a term of 3 years in which the interest represents 10% per year. Based on the compound interest, it would be calculated as follows:
I = 30 000 (1 + (10% / 100%)) 3 = 30000 · 1.13 = 39930
The interest in that term would be equivalent to 39930 – 30000 = 9930
That is, 9 930 euros in our favor or against depending on our position.
Finally, we can affirm that compound interest has a different dynamic than simple interest and that most financial institutions use it, so it will be important to be aware of the obligations we assume and know how they work. At least now you are more prepared to manage your finances more efficiently and consciously to avoid disappointments.