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Investing Rules: Compounding Interest


If you invest money, you will hear the term interest. If you borrow money, you will still hear this famous term. But what is this exactly?


Investing Rules - Rule of 72
"money-profit-finance-business" by nattanan23 is licensed under CC0

A dictionary search defined interest as the amount a lender charges for the use of asset, which is typically noted in annual basis and in percentage.


Interest rates are divided into two categories, simple and compounding. Now, depending on the investment/lending institution, they could be using simple or compounding principle for their rates. It is important that you need to know what kind of rate they are using, especially when you are borrowing money.



What is Simple Interest?


The interest rate is calculated as the percentage of the principal amount. This is usually calculated annually.


Formula


Interest = Principal Amount x Rate x Time


Example:


If you invested Php 10,000 at 3% simple interest annually for 2 years.


it will be


Interest = (10,000 x 0.03) x 2
Interest = 300 x 2
Interest = 600


You will have a total Php 10,600.



What is Compound Interest?


Interest = Principal Amount x (1 + Interest Rate)^Years - Principal Amount


Using the example above:


Interest = 10,000 x (1 + 0.03)^2 - 10,000
Interest = 10,000 x (1.0609) - 10,000
Interest = 10,609 -10,000
Interest = 609


You will have a total Php 10,609.


As you can see, there is a 9 peso difference between the two examples. This may not mean much in its initial year, but remember that in compounding the interest is included in the next computation. Meaning, the principal amount will not remain constant as compared to the simple interest computation.



In the real world, lending institutions love to use the compounding computation because it is more profitable. Especially, if the loan is spread to several years. This is why most loans are offered in 3 years minimum duration.


Bank deposit accounts also uses the compounding principle. However, as enticing as the offer sounds because the interest is compounding. The actual interest rate is small, not even reaching 1% for some regular deposit accounts. And in order for you to appreciate this low interest rate, you need to have a big principal amount.



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Time is what give things value. So don't waste it, invest it.



"The two most powerful warriors are patience and time.”
Leo Tolstoy



- Your Life In Perspective by Ælf ræd (Elf Counsel)

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