Finances: Understanding Compound Interest

In personal finance, whether you are a heavy borrower sinking under the sea of debt or if you are a savvy investor with various sources of investments making money for you, either way compound interest matters.

In personal finance, whether you are a heavy borrower sinking under the sea of debt or if you are a savvy investor with various sources of investments making money for you, either way compound interest matters.

You will either be charged compound interest on the loan you take from a commercial bank or you will earn compound interest on an investment you have made.

People worry not so much about earning compound interest, but are worried about paying compound interest on a debt especially if it is clothed in floral financial language by the Loans agents of your bank.

Compound interest is in fact not very different from simple interest where one earns or pays a fixed percentage of the principal only once.

Instead compound interest is when one pays/earns a fixed percentage of the preclinical over a period e.g. a month or a year and then in the second period, the interest earned in the first period is added onto the principal.

In other words, when you invest money, you earn interest on your capital. The next year you earn interest on both your original capital AND the interest from the first year.

Then in the third year, you earn interest on your capital and the first two years’ interest. Actually, you earn interest on your interest.

For example if you invested Rwf 100,000 for three months at 10% simple interest, you will end up with Rwf 110,000 thousand after the three months.

In instead you earned a monthly compound interest rate of 10%. After the first month, you will have Rwf 110,000, and after the second month, Rwf 121,000 after the three months it will come to Rwf 133,100 (compared to the Rwf 110,000 in the same three months.

The same applies to Rwf 100,000 you take and that is why it I very important for one to understand how much interest they pay on a loan and especially how it is being calculated.

When you have a choice between a good investment with compound interest and a great investment with simple interest, the good investment will have higher returns in the long term.

That is where small savers who do not have lump sum amounts of money to invest can still join the rich league – through consistent saving, patience and foresight.

Albert Einstein, famous physicist, called compound interest “the greatest mathematical discovery of all time” and you can see why he thought so.

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