Compound Interest Pros and Cons

Definition of Compound Interest – Compound is defined in the Oxford concise dictionary as
‘….increase, complicate, …debt by partial payments…’ and whilst none of these definitions directly addresses the issue of compound interest you may begin to see where we are coming from.

Compound Interest is the effect of ‘interest on interest’ and happens when interest is added to the capital or principal sum so that from that moment on the interest which has been added also itself earns interest. If you borrow £10,000 on a credit card at 1% per month after one month you owe £10,100 but at the end of 2 months £10210. After 10 years with no repayments you would owe over £33000 (not the £22,000 you may expect on simple annual interest of 10 years times 12% =£12000 interest plus original principal) This addition of interest to the principal is called compounding (i.e. interest is compounded).

The Positives about Compound Interest

If you have money on deposit earning regular interest your capital grows reasonably quickly.
To demonstrate if you deposit £14,000 in a retirement fund for 45 years at 10% you will retire with over a million pounds. Do you remember the story of a grain of rice on each chess board square being double the last square until there isn’t enough rice grains in the world to cover the 64th square – well compound interest is similar.

If you understand compound interest you can make better comparisons and judgements.
Some mortgages compound every day some every year – which would you choose? Once a year in arrears for preference but in advance at 12% is better than compounding daily that would compound to 12.75% (excluding repayments).

Compound interest is usually the only game in town so take care out there

The Negative of Compound Interest

  • The cost is disguised and can run away with your money.
  • Missing a payment by a day may mean interest falls due to be calculated before the payment is recorded. Time your monthly payments and try to stop them slipping.
  • Compound interest is designed to help lenders. Credit card monthly repayments are usually set so you are encouraged to keep borrowing and thus keep paying interest. Try eat into the capital owed by repaying interest plus some capital every time.

Compound interest was said to be ‘ once regarded as the worst kind of usury, and was severely condemned by Roman law, as well as the common laws of many other countries’. Albert Einstein, when asked what he considered to be mankind’s greatest invention, replied ‘Compound interest!’’

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