Finance – What is Compounding Interest?
Compound interest is something that you will hear a lot about in the world of finance, but what is it?
Compound interest is interest that is calculated on what is known as the ‘initial principle’. It includes all of the interest that has already been added to the loan. Compound interest has been around for a long time. It is thought that it was invented in Italy in the 17th century, as a form of ‘interest on interest’ This type of charge benefits the person that the interest goes to (the lender in the case of a loan, or the saver if it is being paid on some form of savings vehicle). It means that the interest amount increases more frequently than it would if the interest was applied to the principal only.
The interesting thing with compound interest is that the interest accrues at a much higher rate depending on the frequency with which the interest is applied. If you have a balance of $500 and interest of 10% once a year, then the interest will be lower than that applied to a $500 balance with compound interest applied at a rate of 5% twice a year.
How Often Does Interest Get Compounded?
Compound interest is still used in the world of finance from time to time. Interest can be compounded at any schedule. For savings accounts, it is not uncommon for interest to b compounded daily. For mortgages, it is more common for compounding to be monthly. The same applies for credit cards, business loans, and home equity loans.
Where some people get tripped up is that with the system of ‘interest on an account’, the interest may be compounded every day, but then it will only be added to the account once a month. It is only when the interest is added to the account that it is used for the purpose of compounding.
Some banks use a system known as continuously compounding interest. For most people this will not really perform in any way differently to daily compounded interest, however, if you make a lot of transactions every day then you might notice the difference.
Who Does Compound Interest benefit?
Compound interest favors the person that will get the interest. It is good for a creditor or for a person who is investing. It is bad if you are the one who is doing the borrowing. Compound interest can be crippling for credit card debts and other similar high-interest rate borrowing, and a lot of people don’t realize how much of an impact it can have if you carry a balance over several compounding periods. That’s why it’s so important that you pay off your credit card balance every month if possible, or at the very least make significantly more than the minimum payment.
Compounding can work for you, in some cases, though. If you are allowed to make your mortgage payment in installments, making half of it early in the month and the other half at the end, this could actually reduce the amount of interest you pay. It makes sense to run the math and talk to your lender or an advisor.