How to Calculate Compound Interest

Interest is applied on some types of financial transactions. On the one hand, they are the “return”, with the due addition, of a loan made by a natural or legal person who applied the money. On the other, the debtor’s side may represent one of the biggest headaches when it is not well planned …

There are two interest categories: the simple and compound. Usually they are not explicit when closing the loan contract, going unnoticed by the debtor … Learning to recognize them is the “golden key” for you to manage your money better!

We’ve put together here all you need to know about interest rates and, of course, how to calculate the “seven-headed bug” of compound interest. Come on?!

Understand the difference between simple and compound interest

Understand the difference between simple and compound interest

Simple interest is a constant value that is applied over the initial capital and has the same rate throughout the loan period. Usually, it is used for short term loans, whose time varies in each financial institution.

Compound interest is applied to current capital rather than the initial value. This means that it is variable, increasing the amount of your fee by the lending institution within a certain period of time. Compound interest is generally used in medium to long-term financial transactions.

 

Learn to calculate compound interest now

Learn to calculate compound interest now

Unlike simple interest, the compound is variable as time passes. This raises the “time parameter” in the calculation formula of the loan amount. Let’s see how this happens mathematically!

To find compound interest we first apply the following equation:

M = C x (1+ i) t

Where (M) is the amount, (C) is the initial capital, (i) is the interest rate and (t) is the time (usually in years). With this formula, we have discovered the full amount of the loan repayment.

Suppose you borrowed R $ 1,000 for 1 year at a rate of 10%, we have that M = 1,000 x (1 + 0.1) 1 = 1,000 x 1.1 = R $ 1,100. If the loan was for 3 years, we will have that M = 1,000 x (1 + 0,1) 3 = 1,000 x 1,331 = R $ 1,331.

In order to find out the total value of interest (J), we must subtract from the resulting amount (M) the initial capital applied (C), that is, M – C = J. In our specific case we will then have: 1,000 = R $ 331. Right?

This is the amount you will have to pay interest for this 3 year loan which is a not so long term … Imagine real estate loans that come to have terms of 15, 20 or even 25 years!

Now, try to figure out how much you would pay for this same loan if interest rates were simple. Note that this difference will be greater the longer the loan time …

Always consider Total Effective Cost

Always consider Total Effective Cost

Even knowing the exact amount of interest applied on the loan operation, keep in mind that this will still vary significantly due to other fees charged by the financial institution and the government. This is what we call Total Effective Cost (CET).

The CET, therefore, is the sum of interest plus service fees, insurance, Tax on Financial Transactions (IOF) and other taxes. TIP: It can be presented as a percentage of the total value in the contract.

When “masked”, never fail to demand its opening because it is necessary to look at the value of each fee charged within the CET and not just the interest rate. There may be one or more fees hidden there that you can reduce or even eliminate!

Learning how to calculate and differentiate simple and compound interest is the only way to find the best loan or investment to make! Note that not always the physical and legal persons have the same treatment.

Changing in kids: always look for the best condition according to your economic situation at that time and in the time that is most appropriate for your pocket. As a rule is one that does not tighten your budget …

Lastly, always keep in mind that while interest rates may seem low, when applied over long periods, they can accumulate a lot. So it is important to always look for smaller parcels, but always within your budget. Knowing how to calculate compound interest helps you know how much you will pay and not have surprises later. This equation can and should be good for both sides!