Compound interest

Compound interest is interest on interest rate. In this case, the interest projected for the given period becomes capital, and the interest for the next period is already determined on this new capital amount.

The interests rate is usually determined for one year, but the question arises as to what happens in, say, the second year of the term. The interest rate for the second year can also be calculated based on the original capital amount. However, the interest can also be calculated by adding the first year's interest to the capital and projecting the second year's interest onto it. This is when we talk about compound interest. With compound interest, our interest also accrues interest. 

That's a big difference. If we loan $100 at 10 percent interest per year, but at a non-interest-bearing rate for five years, we will get $150 back at the end of the 5th year. Based on this, we calculate the instalments. 

However, if we give the same loan at compound interest, then at the end of the first year, the principal increases to $110. In the second year, the 10 percent interest is already on a capital of $110. The amount of this will therefore be 11 dollars. And in the third year, the interest is 10 percent of $121, or $12.1. In this way, at the end of the 5th year, we should receive $177.2. We also have to define the repayments in such a way that this is their total amount. The difference in this example is $27.2. In both examples, we started with $100, so it really doesn't matter what the rules are.

The situation is complicated by the fact that the interest cycle, at the end of which the interest becomes capital, i.e. it itself begins to earn interest, cannot be defined in just one year. There are bond schemes structures in the world where the interest becomes capital after half a year, and they themselves start paying interest. If we had calculated in this way in the previous example, the total amount repaid would have been even higher for the entire term. 

If you were to give someone a loan, or even more so, if you were to take out a loan, you have to be smart. It doesn't matter whether we charge interests or non-interests, or whether we will pay you back.