Compound interest

The term compound interest is one used frequently in subjects such as finance and also practiced in businesses that deal with lending money and calculating their future income for certain activities. It simply means that when you compute for the next total amount for the next compounding period, you are adding the previous interest as part of the principal amount to be computed as the next total amount of the succeeding period in time.

Of course there are other variations in this method of calculating for a compound interest.
First, there is the simple compounding interest that compounds the principal only once per period of computation. Second, there are the multiple compounding interests. This is where the compounding takes place several times at a single compounding period. Third, you have the multiple compounding interests for multiple periods. This is where the interest is compounded several times.

The term compounding interest is sometimes replaced by other names according to where they are used or the according to the financial institution that is using it. For example, a bank may use the term annual percentage rate or effective interest rate. This is because the computation for the interest rate is usually done on an annual basis. This is why they use the term annual percentage rate or the effective interest rate.

For this reason that the actual interest rate may vary from the time that it is incurred, the government has mandated that the interest rate and compounding frequency must be disclosed to the public. This is especially important to lending institutions because their clients won’t have anything to compare with the other interest rates that are offered to them by other finance firms.
You can imagine your surprise if you suddenly find out that the low interest rate you availed of when you borrowed money is actually charging you a bigger amount than other lending products because you didn’t check the frequency that the interest rate is being compounded. This is where compound interest surprises individuals who happen to be less financially savvy.

Hence it is very helpful for anyone to learn a few terminology used so that they won’t be surprised the next time they take out a loan. It will also help you compare the different financial services better. Periodic rate is the interest rate that is used at the exact time of computation. This can change anytime if you have a compounding interest rate. The compounding period means the length of time that the computation is done. Hence, when your lender specifies the number of compounding period for a year, you will know how many times your interest rate has gone up.

Generally, it is much more convenient to use the effective annual rate for comparison because the computation shows the rate as if the annual compounding rate has already taken place. This will show you the difference when you are comparing with those that use multiple compounding periods within one year. Compound interest also has other variations wherein it is the number of times that they are compounded varies.

A popular anecdote to illustrate the power of compound interest is that of the Manhattan Indians. It is said that if they had invested the money that they had gained from the sale of Manhattan Island in 1626, with a 6.5% interest rate compounded through the years, they would have been able to buy back the island with a lot of money left aside. Not only will they be able to earn more than the value of Manhattan real estate these days but they don’t even have to clean building windows had they been the landlords until this time.