When taking out a loan, there are many aspects and variables to consider. But regardless of your loan choice, you will likely have interest on the borrowed amount that can be broken down into either simple interest or compound interest.
Compound interest is compounded daily, monthly, or annually. When compounding occurs, the interest is added to the amount owed. It can provide lower interest rates, but it’s also riskier than simple interest.
In this article, we’ll explain what compound interest is, how compound interest works, and what the benefits and drawbacks of compound interest are.
What is Mortgage Compound Interest?
A mortgage is a loan that typically applies to real estate where the home works as collateral if regular payments cannot be met. Compound interest can apply to loans of all kinds – but how does it factor into mortgage loans?
Mortgage compound interest means additional interest has been added to the initial loan. The longer unpaid loans sit, the more interest will accrue. When interest is compounded on mortgages, you pay interest on top of interest.
If you don’t want to deal with compound interest, most traditional loans offer simple interest. This version has a fixed rate and provides a set amount to be paid back ahead of time. With simple interest, you never pay interest on top of interest.
Still interested? Let’s better understand how compound interest is calculated.
What’s the Formula for Compound Interest?
How do you figure out compound interest? If you want to estimate the compound interest costs you will face over the years, you can utilize a formula to approximate the amount. Everything you need to find the answer is included in the agreed-upon loan terms.
Here are the components needed to calculate compound interest:
- Principal amount (P)
- Rate of interest in decimal form (r)
- Number of times the interest is compounded annually (n)
- Overall tenure (t)
If you know these, then you’re ready to calculate the owed amount. Now, what’s the formula for compound interest?
Here’s the formula for calculating compound interest: CI = P (1+r/n) ^nt – P.
To solve, plug the described information into the designated spots. Then divide the rate (r) by the number of times compounded (n) and add it to one.
Next, multiply the number of times the interest compounds annually (n) by the overall tenure amount (t). Combine this number and the parenthetical number, then multiply this number by the principal (P). Voilà! Compound interest calculated.
If you still aren’t sure about calculating compound interest, find a Total Mortgage branch near you. Our team of expert mortgage advisors is standing by and would be happy to help you.
How Does Compound Interest Work?
How does compound interest work? What is compound interest on a loan and what can you expect if you borrow money with this designation attached?
As mentioned previously, compound interest is interest on interest. To better illustrate this, let’s look at an example of compound interest on a savings account.
If you put $1,000 in a savings account with 10 percent interest that compounds annually, you will have $1,100 after the first year. The following year, your $1,100 in savings will compound again at the same rate of 10 percent and leave you with $1,210, and so on. You’ll gain an added interest of 10 percent of the amount every year and your savings will grow exponentially over time.
Compound interest can compound in three frequencies:
- Daily
- Monthly
- Annually
Each frequency of compound interest offers varying benefits and disadvantages.
Compound interest has both benefits and drawbacks. In the case of savings, you have the potential to grow your account without additional work. In a loan, it means you have more money to pay off.
Pros and Cons of Compound Interest
If you’re considering taking on compound interest with your loan, it’s critical to make an informed choice by being familiar with the positive and negative effects involved. You want to commit to the option that will help you feel the most secure in your ability to pay off the debt in the future.
Let’s talk about what you can anticipate when taking on compound interest. There are many benefits, but there are also some disadvantages.
What are the benefits of compound interest?
There are many positive reasons to take on compound interest with a loan, which is why many people go with this option when borrowing money. Depending on your financial situation, it may be the best choice for your investment in the future.
Here are a few benefits of compound interest:
- It can provide more affordable interest rates
- Increased payment rates can lessen the interest
These reasons make it easy to say yes to adding compound interest to your loan.
One of the most critical things to note with compound interest is that the quicker you pay off the loan, the less of an impact the compound interest will have. If you can, be sure to increase the frequency of your payments to reduce your overall costs in compound interest.
What are the disadvantages of compound interest?
Now, let’s discuss the drawbacks that come with compound interest on a loan. These make it worth pausing for a moment to think about the effects of your choice in the long term.
Here are a few drawbacks of compound interest:
- It can compound fast
- Accrued debt increases over time
- It’s easy to become overwhelmed with compound interest
For many borrowers, these disadvantages can be difficult to handle – so it’s crucial to be as informed as possible when making your decision.
Many borrowers approach home loans with compound interest under the assumption that they will have little trouble paying off the debt. As time goes on, however, the number (and debt) increases. There’s not much wiggle room to fall back on if you start to lose control of the compound interest attached to your loan.
If you ultimately choose to take on compound interest, a monthly frequency will likely have a lower rate than annual options. Contact a Total Mortgage loan expert for full details about compound interest.
Explore Total Mortgage’s Loan Options
What type of loan is best for you? Is a low-rate loan with compound interest a solution? Let us help! Explore one of Total Mortgage’s many locations to find the ideal loan options for you. We’re here to help you feel confident in your decision. You can also apply for a loan online and get a free quote.
Source: totalmortgage.com