Simple Vs. Compounding Interest

Compound interest is the 8th wonder of the world. He who understands it earns it. He who doesn’t, pays it”. This quote is attributed to Albert Einstein. This graph may be able to explain why:

Put simply, when the interest is paid at the end of each period and is not added to the beginning balance of the next period, we have a simple interest loan. On the other hand, if the interest for a period is not paid at the end of the period, the unpaid amount of interest is added to the next period's balance. Since the principal amount is added to at the end of each period, this type of loan arrangement has a compounding effect and thus is called compounding loan. Each period during the life of the loan (loan term) is called the compounding period. Because the principal amount is increased at the end of each compounding period by the earned interest for that period, the total interest earned at the end of the term of the loan is more than the interest if the interest were to be calculated as a simple-interest loan arrangement (once and only at the end of the loan term). That's the concept in a nutshell. Now, let's look at some examples.

If you borrow $1,000 from your parents and pay them 5% at the end of each year for 5 years and return the $1,000 at the end of year 5, you have a simple financing arrangement. Each year, the principal stays the same, $1,000. At the end of the 5-year term, you have paid 5 interest payments, each of which is $50, for the total of $250. On the other hand, if you put your money in a 5-year GIC account where you would receive the principal and interest at the end of year 5, but the interest for each year is added to the principal for the next year, you have a compounding loan agreement. At the end of your GIC term, your money has earned

Real estate financing agreements are either simple interest or compounding interest. If your financing agreement requires you to pay both the interest for the month and a portion of the principal, you have a conventional loan agreement. The prime example of this type of loan is the residential mortgage agreement. When you buy a house, in each of your monthly mortgage payment, you pay a fixed monthly amount. This amount includes the interest for the fund borrowed for the month plus some portion of the principal. In an interest-only financing agreement, you do NOT pay any part of the principal for the lifetime of the agreement. All you pay is the interest for the use of fund. This is typically the arrangement for construction financings. It lowers the cashflow burden for the builder while lowers the risk for the lender if the project goes bankrupt.

Assume you borrow $100,000 based on compounding interest. If you get to use the money without paying the interest in each month, the outstanding interest for the month gets added to the principal. So, the next month principal is the last month principal plus the amount of unpaid interest. In a simple interest financing agreement, you pay the interest for the month at the end of each month. So, if you borrowed $100,000 through a simple interest loan agreement, the amount of principal for each month would be what you started with in the beginning of the loan term, which is $100,000.

After you sell the project, the agreement typically requires that you first pay the lender for any outstanding balance. Once the lender is fully paid, any outstanding amount will be left for the builder. That wasn’t too hard, was it? In the next piece, we are calculating interest for simple and compounding loan agreements. Please subscribe to our channels on YouTube, Instagram, Twitter, and our mailing list below. Subscribers will receive priority access to our deals.