A compound is simply a material comprised of many similar substances, usually composed entirely of hydrogen atoms but also consisting of multiple oxygen atoms and even more than one carbon atom, bonded together by some sort of chemical bond. A material composed entirely of hydrogen atoms is in reality not a compound at all, but a gas. What is compound number two is different. In this case the chemical bond between the carbon atoms is stronger than that between any other element, so two-carbon compounds are not the same.
Some people have a problem with what they perceive as the definition of a compound, since compounds can be derived from solvents, or inorganic compounds formed from inorganic substances. But it is the inorganic materials that we’re interested in here. If you’re taking out a mortgage with a bank and they ask you what is compound interest, they are asking you what you’re using to compute that interest rate into your loan amount. They do not want to know what type of compound you’re making and whether or not the interest rate is being derived from compounding. They just want a straight loan term and interest rate, period.
The simple interest calculation would be, for instance, “Assuming I am refinancing an existing account with a fifty dollar loan term and a six percent interest rate, and I am also taking out a one thousand dollar loan with a fifteen percent loan term and a five percent interest rate, then I will earn four hundred and sixty thousand dollars over the life of the loan.” That is compounding, the earning on the principal amount of the loan plus the interest, and assuming no compound interest is applied to the principal amount. This is called simple interest, which is all that matters in the financial world.
A compound interest assumption is when you take out a loan, put your money in a savings account earning compound interest, and then let it compound for the full term of the loan and its corresponding interest rate. Assuming that interest earns a total annual return of nine percent, then you could earn a profit of approximately nine thousand dollars per year. In today’s economic milieu, anyone wanting to earn money with something such as compound interest at their fingertips has to have some capital. Most banks do not lend out large sums of money without some investment or collateral. For those people who want to utilize this investment concept without risking their own money, there are other alternatives.
Some people earn interest through simple interest, reinvesting dividends received from the stock market, or from other investments like certificates of deposit. Others earn it by borrowing from family, friends, or taking out a loan from the bank. There are a number of opportunities to earn money with compounded interest; however, if you are just starting out in life and looking for ways to generate additional income, you should focus on these. It is best to start small and build your way up.
Compound interest is most commonly found in a two-period mortgage, also known as ARM, where the interest rate is fixed and stays that way for the entire term of the loan. This type of mortgage allows one to earn money by compounding interest over long periods of time, with the interest rate level dependent on current interest rates. In order to capitalize on compound interest, a loan needs to be taken out with a longer loan term; however, the longer the loan term, the more compound interest is earned. Those with long terms can earn more than double the interest rate of those with shorter terms, so there is no reason to settle for just the short-term interest rates offered by the bank.
There are different methods of compounding interest, but all of them employ the principle of compounding over long periods of time. The simplest of these methods involves applying the initial principal and the amount of interest earned over the term of the loan. A simple interest rate may not provide a large enough compounding effect. However, there are still other compounding methods such as the accelerated pay down, or annual return method. Each of these methods has its pros and cons, depending on the initial principal and the amount of interest earned per period.
To calculate compound interest, a financial or business advisor or accountant should be consulted. Most calculators will have pre-formatted formulas for calculating this effect, but it is always best to obtain a custom-calculated formula that suits the individual investor’s needs. For those who are unfamiliar with the concept, a quick overview of compound interest is essential to understand how it works. Basically, compound interest refers to the earning potential of an investment due to compound interest being applied to the initial principal. For example, if an investor receives a fifty percent return from a bond, that individual will profit from every nickel that he or she invests. There are many variables that can affect the return potential of any investment, but a financial advisor will be able to calculate a more accurate figure.