The Inner Workings of Compounding Interest Rates

Compounding interest rates. We hear of them daily - in the the news, in the paper, on the streets (Wall Street especially), around the office, even at home.

But do you really know how interest rates work? Or what compounding is?

The bottom line is that interest rates create incentives for people to perform specific action. Take someone borrowing money for example. That person has an incentive to pay back the amount owed due to the interest rate on the base amount (principal). Knowing that the longer they hold the debt the more money they will end up spending, it creates incentives for people to repay their obligations.

The same can be said for investing in regards to interest rates and incentives. All other things being equal, as the individual investors possible return (interest rate) goes up, so does his/her their incentive to put their money into the market rather than withhold it, which leads to strong economical foundations.

The calculations involved in computing the end result of an investment or payment that is interest accrued is relatively simple. There are however a few things you need to know before you can determine the values and returns using interest rates.

First, you need to know the interest rate. You also need to know if it is compounding. When I speak of compounding, I refer to earning interest on the interest. The more frequent the compounding, the more money you will make or owe. The most typical compounding periods are annually, semi-annually, quarterly, monthly, and daily.

So let's do a quick example. Let's say I need some cash, and you're willing to lend it to me as long as I promise to repay at 6% interest. Let us also assume I'm a nutcase and agreed to your terms of daily compounding. So, you loan me $1,000 at 6% compounded daily for 10 years. At the end of the 10 years, I would owe you $1,822.03

Now, just so you can visualize the difference in compounding, let's take the same example with the same figures, and just compound it quarterly, or four times a year for 10 years. I would owe you $1,814.02 in this case.

The effect of the compounding frequency is directly related to the current balance owed and obviously the interest rate you lock into or fluctuate to if you hold a variable rate (one that changes).

You'll most likely find credit card companies to have daily compounding interest rates. This may seem unfair to those that use their cards, but you have to understand that a large percentage of people that get credit cards are unable to pay that money back, more so than any other form of lending, so they need to make up for that loss by milking those who can and do pay for as much as possible, while still being relatively discrete about it. Don't believe me? Go read the fine print on your next statement. Other forms of lending, like mortgages, compound monthly.

Hopefully this short deliberation helps you grasp the concept of compounding interest rates a little better, and perhaps helps you make better financial choices when borrowing, lending, or investing money in the future.