How does compound interest affect bills? | Small business


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Compound interest refers to the excessively rapid accumulation of interest charges on a loan or deposit. The cumulative effect can dramatically increase the money owed and can seriously affect your finances. When your business owes money and bills increase at a compound rate, spending can quickly spiral out of control.

Compounding

The concept of composition is quite simple, but its effects are surprising. Stacking is the accumulation of interest charges at an increasingly rapid rate. If, for example, you owe $ 100,000 and you pay 10% interest per year, the debt balance will increase by $ 100,000 times 10% – or $ 10,000 – in the first year. However, if you do not repay this loan at the end of the first year, the interest charge for the second year will be more than $ 10,000. The total debt on which interest charges will accrue in Year 2 is $ 110,000. Therefore, the interest charge for the second year is 10% of $ 110,000, or $ 11,000.

Examples

The effect of compounding is more pronounced if interest charges are assessed frequently. Consider two loans, one with a monthly interest charge of 1% and the other with an annual fee of 12%, both with $ 100,000 as a starting balance. In a year, the first loan will turn into $ 112,683 while the second loan will be $ 112,000. The formula for the outstanding balance of a compound loan at a fixed rate is: Balance = Original loan multiplied by ((1 + interest rate) increased to the power of n). Here, the interest rate is expressed in decimals and “n” is the number of periods. A monthly rate of 1% for 12 months will therefore transform an initial loan of $ 100,000 into 100,000 times ((1 + 0.01) increased to the power of 12), or $ 112,683.

Effect on invoices

Compound interest will affect your bills if you miss more than one compounding period. To avoid this, you should read the fine print explaining the interest charges and penalties. If, for example, the invoice has a late charge of 2% per month, there will be no compounding if you pay before a full month has elapsed after the due date. If, however, you pay two months after the due date, an initial balance of $ 100,000 will change to ($ 100,000) * (1 + 0.02) ^ 2 = $ 104,400. Here, the effect of compounding is $ 400, since you paid 2% of $ 100,000 twice. The longer you wait, the greater the cumulative effect.

other considerations

The effect of compounding on invoices may even be greater if the agreement between you and the lender has additional penalties or other clauses. If the contract states that payments not received within 60 days of the due date result in an additional late fee of $ 750, which is also subject to interest charges, the loan will grow at an even faster rate afterwards. 60 days. In some cases, the monthly or weekly interest rate may increase if you wait longer to pay. While the first month’s interest can be 1 percent, this figure can increase to one and a half percent per month after 30 days.

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