How Compound Interest Works
Compound Interest Formula
Compound Interest and Home Loans
Compound interest is one of the most technical and crucial aspects in the world of finance. Unlike simple interest, compound interest grows exponentially with time. The phenomenon can be very beneficial for you if you are investing in real estate or any other field as it would multiply your returns gradually. On the other hand, the concept of compound interest works against debtors as it continually increases the amount of debt within the specified time frame.
How Compound Interest Works
Compound interest is commonly known as “interest earned on interest.” It is an amount added to the initial principal sum of a particular loan or capital amount. This financial phenomenon is based on the process of re-investing the interest gained, instead of, utilising or investing it elsewhere. This re-investing cycle takes place in regular intervals during the given tenure and is known as a compounding period, the repetition of which depends on compounding frequency.
What is Compounding Frequency?
Compounding frequency determines the number of compounding periods usually in a year. It determines the number of times the accumulated interest is collected on the intended loan or capital amount.
Compounding periods are usually annual and biannual. In an annual compounding period, interest is compounded once a year, whereas, interest is paid after every six months (twice a year) in a biannual compounding period. According to the general rule of thumb, the higher the compounding frequency, the greater the amount of accrued compound interest during the given investment or financing tenure.
How to Calculate Compound Interest
If you know the right formula, it would be easier for you to calculate compound interest. Below we have shared some of the most commonly used formulae, which have also been mentioned by world-famous online magazines including Business Insider and Investopedia.
Equation 1: P (1 + r/n)^nt
A = Total Amount
P = Principal Amount
r = Annual Rate of Interest
n = Number of compounding periods
t = tenure for which money is deposited/invested or borrowed (usually calculated in years)
Example: Let’s suppose you have applied for a two-year loan of PKR 200,000 at an interest rate of 10%, which is compounded bi-annually (4 compounding periods). How much compound interest would be incurred on your initial loan amount during the financing tenure? Let’s find out by using the aforementioned formula:
Calculation: PKR 200,000(1+0.1/4)^4×2 = 243680.5
The answer this formula gives you is PKR 243,680.5. Well, it would be the total amount you’d have to pay for the loan you have borrowed. And, this means the accrued compound interest on the initial loan amount is PKR 43,680.5.
Equation 2: [P (1 + i)^n] – P or P [(1 + i)^n – 1]
P = Principal Amount
i = Nominal annual interest rate (calculated in percentage terms)
n = Number of compounding periods
Example: Let’s say you have decided to deposit your annual bonus of PKR 100,000 for three years at an interest rate of 5% that compounds on a yearly basis. How much compound interest would you earn on your initial investment? Let’s calculate it!
Calculation: [PKR 100,000(1+0.05)^3 – PKR 100,000] = PKR 15762.5
This way you’ll earn PKR 15,762.5 interest on your deposit in three years.
Compound Interest and Home Loans
When it comes to home mortgage loans and home equity loans, the most commonly applied compounding period is monthly. However, there can be variations in the accrued interest amount according to the initial amount borrowed and the length of its tenure.
Interest on the invested or borrowed amount may be compounded daily but it can only be credited on a monthly basis. The interest is then credited and/or added to the existing balance. This is how the additional interest starts to accumulate on the principal amount — multiplying your investment or debt with time.
Now that we have given you all the useful information about the phenomenon of compound interest and how it is calculated for home loans, financing facilities and other types of investment purposes, it’s time for us to wrap up.
On a side note, you may also like to take a look at our other comprehensive guides on how to calculate ROI in real estate and the importance of rental yield in the terms of property investment and management.
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