HomeNEWSCompound interest: how does it work?

Compound interest: how does it work?

Compound interest comprises the variation in which the interest rate is modified in a variable way, in which it is calculated on the amount of the previous year. It is widely used in long-term financial operations.

Compound interest can be an ally or a villain for an individual, it also depends on how it is used. In loan cases, debt increases, and in investment situations, profit grows.

What is compound interest?

Compound interest is the name given to the type of interest that varies in a variable way, always basing its calculation on the previous amount. In this way, the growth of interest ends up being exponential, with a much faster increase.

In summary, compound interest will always have the last adjusted amount as the calculation base, thus making it an addition to the previous amounts that gradually grows exponentially.

Source/Reproduction: original.

In practice, compound interest works as follows. Imagine if a person invests R$ 200.00 of their money today in a bond that will earn R$ 20.00 monthly.

In the next month, it will turn into R$ 220.00, which will serve as the basis for calculating the following month. Briefly, instead of the calculation being done on top of the initial BRL 200.00, it will be done on the following variations.

The process of calculating compound interest grows similar to that of a snowball, in which it starts small by handfuls and when it falls to the ground like this, it joins with more snow. That way, the more it descends, the more it grows and more and more it becomes fast and big.

When is interest compounded?

The calculation of compound interest comes into play when long-term financial operations occur, such as investments and financial loans. Before explaining more about when compound interest comes into play, it’s worth talking a little about the concept and history of interest in general.

In short, interest comprises the financial compensation charged on a monetary resource that was borrowed. In practice, it would be a way of guaranteeing that the amount borrowed would return to the economic grantor.

Etymological analysis, the word interest is derived from jus, a Latin term that refers to justice, equity and law.

It was created during the ancient Roman Empire, where it was directly linked to credit risk. In this way, when Rome lent financial resources to traders traveling to the Asian continent, in which due to the risk of the operation, they accompanied a financial amount that increased in relation to the initial amount borrowed.

When is interest compounded?
Source/Reproduction: original.

Throughout history, this amount of interest has been creating calculations and standards to be charged. From this, the compound interest theory was developed, originating from the existence of high risk credit operations.

In this way, the compound interest calculated on top of the last variation of the installment guarantees a certain return for loans or high-risk financial investments.

In short, it was evident that compound interest is levied on financial operations that have a high degree of risk. Either because it involves high monetary values ​​or delay in returning the borrowed amount

How is interest calculated?

The calculation of compound interest is performed on the last variation of the installment. In summary, if the individual takes out a loan of R$ 7,000.00 divided into 12 installments of R$ 583.33, with a variation of R$ 20.00 on the initial amount that will be added on top of the other installments. Check out how all this looks in practice in a schematic way:

  • 1 – BRL 583.33 + BRL 20.00 = BRL 603.33
  • 2 – BRL 603.33 + BRL 20.00 = BRL 623.33
  • 3 – BRL 623.33 + BRL 20.00 = BRL 643.33
  • 4 – BRL 643.33 + BRL 20.00 = BRL 663.33
  • 5 – BRL 663.33 + BRL 20.00 = BRL 683.33
  • 6 – BRL 683.33 + BRL 20.00 = BRL 703.33
  • 7 – BRL 703.33 + BRL 20.00 = BRL 723.33
  • 8 – BRL 723.33 + BRL 20.00 = BRL 743.33
  • 9 – BRL 743.33 + BRL 20.00 = BRL 763.33
  • 10 – BRL 763.33 + BRL 20.00 = BRL 783.33
  • 11 – BRL 783.33 + BRL 20.00 = BRL 803.33
  • 12 – BRL 803.33 + BRL 20.00 = BRL 823.00
  • TOTAL AMOUNT = BRL 8,599.63

In this example, we saw how compound interest exponentially increased the debt that the borrower has with the bank. It raised BRL 1,599.63 compared to the BRL 7,000 borrowed at the beginning. On the other hand, in cases of investment, the individual who carried out the operation ends up making a good profit.

What is the difference between simple and compound interest?

The main difference between simple interest and compound interest is in the way of calculating the change in the value of the installment.

While the simple is calculated on top of the total value, the compounds are calculated on the total amount plus the value of the variation of the past installment.

Simple interest is usually charged on operations involving short-term loans, while compound interest is charged on long-term credit operations.

Final considerations

During the course of the article it became noticeable how much knowledge about compound interest is quite important, mainly because of its ability to increase the amount of a debt or an investment.

Based on knowledge about compound interest, citizens will be able to better discern whether it is worth submitting to certain bank loans or even where to best invest their money.

Finally, the article showed how understanding about compound interest helps a lot in organizing and managing our own finances.

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