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Compound Interest

Compound Interest is interest that is paid on the principal amount plus the accrued interest from previous periods. Compound Interest is the standard in most finance and economic practices. To fully understand the affects of Compound Interest one must take into account the interest rate and compounding frequency. Compound Interest is calculated differently from simple interest and yields a higher effective annual rate of interest on a loan. It is calculated at the end of a specified period shorter than one year. The interest rate calculation is important to investors in mortgages related to investment properties or loans that an investor may provide to a buyer when selling that investment property. For example, an investor offers the buyer of an investment property a $100,000 loan with an interest rate of 10%, interest-only annual payments, and the principle balance due in seven years. If the loan is a simple interest loan, the annual payment on the loan is $10,000. If the interest is compounded every month, the calculation of the interest rate for the first month is $100,000 times 10% divided by twelve (12). That interest is then added to the principal balance of the loan to calculate the second month’s interest. As the interest for previous months is added to the principal balance used to calculate each month’s interest until the end of each year, the annual payment owed using monthly compound interest on this loan is $10,471. Over the life of the loan the investor earns $3,297 more with monthly Compounded Interest than if this were a simple interest loan. The effective rate on this Compound Interest loan is 10.471%. Compound Interest rate comparison charts and calculator tools are widely available on the Internet.

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