Compound Interest

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Representative Example: Representative 1286.98% APR on a loan of £300.00 with 5 monthly repayments of £101.03 Total amount repayable £505.13 Annual interest rate (fixed) 290%

 

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Author: External Writer

 Editor: This is an interesting article about Compound Interest, however it should be noted that the loans offered by BFWG Grants only apply Simple Interest.

As stated by Albert Einstein, compound interest is "The greatest mathematical discovery of all time". There isn’t any scope of doubt about this genius mathematical mastermind’s comments. Unlike the calculus we studied in high school, compound interest has been applied to every step in our life and the ramifications are substantial. That is why it is of utmost importance to understand how to work it in our favor and not against us.

The facts of how compounding turns regular money into an income yielding mechanism with a well devised investment plan could have been an asset to learn from school time. But now is as good as a time to start. Compound interest best works on two things: re-investment and long time. The more time is given to it, more the yield becomes. But is it enough to just invest to have a substantial fortune at the age of 50? For most people, planning is a big constraint they lack on. Good planning can turn even small investments into huge profits. We’ll try to demonstrate that to you with a comparison study.

 

Take a look at the example:

Suppose you invest £20,000 for 20 years on 5% annual compound interest rate. This will yield you £53,065.95 at the end of said 20 years. So the profit to be noted here is £33,065.95 that is almost one and a half times your capital.

But what if you had planned the investment even better? How could that have worked in your favour? Let’s take a slightly different calculation this time.

Say you invested £15,000 for 40 years on 5% annual compound interest rate. The amount is less than you had before but you start investing early in your life and keep the turn over time a little longer. This will yield you £105,599.83 at the end of said 40 years. So the profit to be noted here is around £85,000. Think we made a mistake in the calculation? Check again for yourself. Yes, that is how compound interest works.

Re-investing is the key to success on long term investments. This is the lesson to be taken in this example. If you want to earn a fortune from compound interest, start early and keep it long. Sure it takes time and a lot of patience, but check the calculation again and decide for yourself whether it is worth the wait or not.

When does Compound Interest turn against you?

When it comes to compound interest, the receiving end is the best side of the game. The other end of the compound interest is not so much fun.

Loans: Startup businesses and individuals risk their position in dire situations by opting for loans. And if the loan is working on compound interest then God save you. But we do have some suggestions that could make your life a little easier even when you are the payee of compound interest. First of all, if the loan is long term, turn around and look for another option. This is not a battle you can win in case you are not wealthy to begin with or plan on getting filthy rich very soon. If the occasion is unavoidable, we have some real advice. First would be paying off as soon as you can, even if that might not help you much in a long term loan. If this does not work for you, the last straw is, pay off at each installment more than the minimum budget. You may think this is not going to make any impact, but definitely it will. That little extra does matter.

So what is the alternative - Simple?

Take the same calculation from above and think that this time you are not the investor but you are the borrower, and you borrow £20,000 for 20 years on 5% annual compound interest rate. This will cost you £53,065.95 at the end of said 20 years. The loss here is some £33,000.

The same calculation in simple interest will work like this: This will cost you £40000 at the end of said 20 years. You have to pay off £20,000 more than you have borrowed.

Difference between the two is £13,000. Do you consider this substantial? So do we.

If you plan to make some savings or a little fortune in your life, try not to indulge in both of these. Simple interest works in your favour you are borrowing and compound is best if you are saving.

Editor: The figures used in these examples have not be validated for accuracy and are for illustrations only.