Simplifying Compound Interest

Over time, interest rates can have profound effects on the financial health of your company. A complete understanding of how interest payments are calculated will help you understand exactly what “signing on the line” can cost you.

An earlier post detailed the true costs of debt to a growing business. Matters like bank fees, time dedicated to servicing the loan, and interest charges were all explained.

But it turns out that even accomplished business people are often a little foggy about exactly how compound interest works and the impact it can have on their personal and corporate finances.

Simple Interest

Simple interest is basically how you were taught to calculate interest in elementary school. Simple interest is determined by multiplying the amount borrowed (or principal) by the assigned interest rate.

For example, 8% interest on $5,000 is $400.

But this is not how most businesses or banks calculate the interest owed on money lent to you. If you assume so, you’re going to be out a lot of money.

The Real Deal

So how else would interest be calculated?

Many organizations (such as banks and credit card companies) use compound interest to calculate how large your finance charges are and how much interest (in dollars) you are actually charged. In fact, most financial institutions and other companies that extend credit to you use compound interest, calculated monthly.

Using our example above, a simple interest calculation brings the amount owed to $5,400, ($5,000 loan amount, $400 interest). But if we compound the interest each month, our calculation is a bit trickier, as we have to figure the balance at the end of each month.

At the end of the first month, you have accrued 1/12th of the interest charges that would be due at year-end.

So, 1/12th (.08333) of 8% (.08) of $5,000 = $33.33

So we add $33.33 to the $5,000 to get a starting balance of $5,033.33 at the start of the second month.

We repeat this for each month (during the second month, it earns 1/12th of 5% of $5,033.33. and so on…).

At the end of the year, you owe $5,415, which is $15 more than if just simple interest were being applied.

Is $15 a lot of money? No. But this example is illustrated with a small loan amount and relatively modest interest rate. And it’s a 3.75% increase over what would have been paid in the simple interest situation.

The lesson: As the loan amounts increase, or as interest rates are raised, the effects of compounded interest are substantial.

Many easy to use compound interest rate calculators are available online.

Try the Money Chimp Calculator.

or,

Webmath’s compound interest tool.

What it Means

Whenever borrowing significant sums of money, make sure you understand exactly what is being offered.

Take your bookkeeper or accountant with you if you like.

Read the fine print. Shop around and negotiate for a better rate.

And above all, don’t borrow unless there are compelling reasons to do so. Invoice factoring can be a better option than taking on more debt. MP Star Financial can offer solutions. Call for more information. (800) 833-3765, extension 150.

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