When it comes to calculating interest, there are two choices: simple and compound. Simple interest is based on a certain percentage of the principal amount every year. On the other hand, compound interest is a sort of ‘interest on the interest’ that happens when you reinvest your earnings and, in the process, also earn interest.
Compound interest, also called compounding interest, is the interest that is added to the principal amount after each period. It also includes accumulated interests from previous periods based on the frequency schedule, which could range from continuous, daily, or even annually.
Compound interest is calculated based on an exponential growth factor equation.
Compound Interest = [P (1 + i)n] – P
OR
P [(1 + i)n – 1]
Here, P = Principal, i = nominal interest rate (usually represented as a percent), and n = number of compounding periods.
Principal refers to the starting amount upon which the interest is calculated. In real estate, it refers to your original investment amount. There may be situations where the frequency of compounding periods is more than once within a year, so the values of i and n must be adjusted accordingly. In other words, the “i” value should be divided by the compounding frequency per year. Also, the value “n” represents the number of compounding periods per year multiplied by the loan’s maturity period (in years).
Because compounding interest is an exponential growth equation, the interest amount is not the same every compounding year. Hence, when integrated into the principal amount, it increases the interest calculation in the next period, and so on till you either stop investing or until the interest is fully paid.
For instance, a real estate investment with a deposit of $10,000 at a rate of 5% would yield a compounding interest of $6,288 over a period of 10 years if interests were paid annually. But if interests were paid monthly, the interest would steadily yield $6,470 within the same period of 10 years.
Interest can be compounded on any given schedule. That is, it can range from daily to annually. For compound interest, the compounding frequency makes the difference. While it is possible to assume that interest is calculated once in a year, in most usual practices, interest is calculated more frequently in daily, monthly, or even many other possible compounding intervals. The more frequent the compounding interval, the faster the growth.
Compounding interest has some special considerations within the concept of real estate investing. It is closely tied to two major investing concepts, namely: The Time Value of Money and The Rule of 72. This gives real estate investors insights into how they can optimize their income and wealth allocation by looking into the present value of money and the future value of money.
Future Value = PV (1 +i)n and PV = FV / (1 + i)n
The Rule of 72 estimates the time required to double the invested money based on the same rate of return.
It is calculated using the formula (72/i), where i = interest or annual rate.
For instance, a real estate investment with a rate of 6% will double in 12 years, and one with a rate of 9% will double in eight years.
Compounding interest can be investors’ best friend given that they understand how to make it work. For instance, if you invest $100,000 at an interest rate of 10%, you would have $1,083,470 in 25 years at an interest rate of 10% if you do not contribute anything. However, at a simple interest, you would only have $350,000, a solid reason that justifies why compound interest is more beneficial for investing. Compound interest is what makes many investors so successful and wealthy today.
