The importance of the compound interest rate

Almost all financial products are offered with a compound interest rate. This rate is responsible for the success of banking in the world. What does it consist of?

The compound interest rate is the life of all the world’s financial systems. I would love to meet the one who invented the formula. That person realized that the goal of lending money is to make, in time, more money, to lend more, earn more, lend more and so, exponentially.

Suppose you have $ 10 million pesos. You don’t need them for anything in particular. You decide to lend them to a good friend, Juan . They agree a rate of 1%. The first month, the friend pays you $ 100,000 (10,000,000 x 0.01). That same week, Carlos asks you to borrow money. You inform him that you do not have a large capital and you could lend him $ 100,000 per month. Perfect, just what he needs. They fix the terms of the business. Again, you estimate the rate at 1%. You will earn $ 1,000 for that loan (100,000 x 0.01)

A month, Juan pays $ 100,000 and you lend that money to Carlos. You earn $ 101,000.

A month, Juan doesn’t pay and you can’t lend Carlos the agreed money. You will not be able to earn the pesos that Carlos’s credit left you.

Bad business. You should be able to earn that money. What can you do? Juan can’t harm your business. You must re-calculate.

To avoid the risk of stopping increasing the magnitude of money over time, of not allowing the cost of your money to be lost over time, you should do the entire business with Juan, with a compound interest rate, not simple.

What is a simple interest rate and a compound interest rate?

What is a simple interest rate and a compound interest rate?

There are businesses that are agreed with a simple interest rate. The interest will always be the same in each month, for the entire duration of the business. In the case of Juan and Carlos, a simple rate of 1% (0.01) was agreed.

The compound interest rate constantly re-invests interest during the entire period of the business, accumulating capital . It works like this: when you invest in a fund and decide not to withdraw the interest it produces each month, each month (worth the redundancy) you will have more capital on which the interest you will earn in the following month will be settled.

Your investment would look like this:

This saving is calculated with a monthly effective 1% rate (just as an example, it is not the commercial market rate). In the case of deciding that each month you withdraw interest, the fund would pay you $ 1000 and each month you would have the same capital and produce the same interest, the same $ 100,000

Instead, your decision was not to withdraw interest. The effect is that your capital grew month by month and interest was higher month by month (they started at $ 10,000,000 and ended at $ 10,500,000).

How the compound interest rate works on a loan

cash

Now, how does the compound interest rate on a loan work? Basically, the same.

Let’s review Carlos’s case again. What should not happen is that he stops paying the monthly fee, because it will prevent you from lending that money and generating a new profit. You will have to assume that you lend it back to Carlos – and not to Juan – the S / 100.

How?

You will accumulate interest earned on borrowed capital.

Ex: reduced to $ 10,000 initial pesos

As you can see, the interest generated is added to the capital each month and generates the same interest paid by Juan and Carlos: 100 and 1.

The same thing happens in a loan. The interest generated is added to the borrowed capital and the fee you pay is subtracted . That is why it is indicated that the growth of credits is “exponential”, because capital increases month by month.

Bad business?

money

Absolutely. A teacher taught me that, if you know the rules of the game, you will learn to play better. If you know that the compound interest rate of your credits can increase the cost of money, you will learn to better manage your money and lower your accounts, lower the interest you pay month by month.

About the Author