Compound Interest –
What Is It
How Can You Calculate It?
As taking out loans have become quite popular in the recent few decades, the concept of interest rate and the related calculations have become an interesting topic to deal with. The interest payments for some loans are calculated through simple interest payment calculation while other loan options choose the compound interest rate payment. Though the concept of compound interest rate may be difficult to understand, with proper professional help, you will be able to master it.
Compound interest is opposed to simple interest in various ways. In case of simple interest rate, the interest is not added to the payment. Thus, there is no compounding. Though there are certain financial products which include various aspects of simple interest, in finance and economics, the concept of compound interest gets more importance.
Factors included while calculating compound interest
It should be noted that the effect of the compounding depends on the frequency with which interest is compounded. It also depends on the periodic interest rate which is applied. Apart from these, there are various factors which impact the calculating of the compound interest. Let’s take a look:
Effective annual rate: This is a rate which reflects the annual compounding. This actually describes the total accumulated interest that can be paid till the end of a year after dividing by the principal. For any kind of comparisons, the economists and financial experts take into consideration the effective annual rate though the periodic rate is quoted normally.
Periodic rate: This is the interest rate which is charged after being compounded, for each period after being divided by the amount of the principal. It should be noted here that the periodic rate is mainly used for calculations. It is not used for any kind of comparisons. Also, you should remember that the nominal annual rate, or nominal interest rate as it is popularly known, is the periodic rate which is multiplied by the number of compounding phases every year. Thus, it should be noted here that the annual nominal rate of 12% will be same as the monthly rate of 1%.
However, the loans and mortgages, may have other fees and charges, which are “non-interest”, attached to it which is not taken into consideration by the above two factors. Also, the above mentioned factors may have different references and meanings depending upon regional customs or marketing demands, etc.
Options where compound interest is not used
Compound interest is not used in case of Canadian and US T-Bills. Apart from this, compound interest is not used in case of corporate and government bonds in many cases. Also, Canadian mortgage rates are compounded semi-annually and not like normal compound rate. The US mortgages also use the amortization option rather than compound interest option. In this option, there is an amortization schedule which helps the borrowers know how the payments will be applied toward the mortgage – interest as well as principal amount.
Hopefully, now you have got a basic idea about compound interest and how it is calculated. If you are dealing with compound interest and cannot sort out the matter, it will be better to get in touch with a financial expert in this regard.