Almost all financial products are offered with a compound interest rate. This rate is responsible for the success of banking in the world. What does it consist of?
The compound interest rate is the life of all the world’s financial systems. I would love to meet the one who invented the formula. That person realized that the goal of lending money is to make, in time, there is more money, to lend more, earn more, re-lend more and so, exponentially.
Look at the simple:
Suppose you have S / 10,000. You don’t need them for anything special. You decide to lend them to a good friend, Juan. They agree a rate of 1%. The first month, the friend pays you S / 100 (10,000 x 0.01). That same week, Carlos asks you to borrow money. You inform him that you do not have a large capital and you could lend him S / 100 monthly. Perfect, just what he needs. They fix the terms of the business. Again, you estimate the rate at 1%. You will earn S / 1 for that loan (S / 100 x 0.01)
A month, Juan pays S / 100 and you lend that money to Carlos. You earn S / 101.
A month, Juan doesn’t pay and you can’t lend Carlos the agreed money. You will not be able to win the sun that Carlos’s credit left you.
Bad business. You should be able to earn that sun. What can you do? Juan can’t harm your business. You must recalculate.
To avoid the risk of stopping increasing the magnitude of money over time, of not allowing the cost of your money to be lost over time, you should do the entire business with Juan, with a compound interest rate, not simple.
What is a simple interest rate and a compound interest rate
There are businesses that are agreed with a simple interest rate. The interest will always be the same in each month, for the entire duration of the business. In the case of Juan and Carlos, a simple rate of 1% (0.01) was agreed.
The compound interest rate constantly reinvested interest during the entire period of the business, accumulating to the capital . It works like this: when you invest in a fund and decide not to withdraw the interest it produces each month, each month (worth the redundancy) you will have more capital on which the interest you will earn in the following month will be settled.
This saving is calculated with a monthly effective 1% rate (just as an example, it is not the commercial market rate). In the case of deciding that each month you withdraw interest, the fund would pay you S / 100 and each month you would have the same capital and produce the same interest, the same S / 100.
Instead, your decision was not to withdraw interest. The effect is that your capital grew month by month and interest was higher month by month (they started at S / 100 and ended at S / 105).