August 20, 2025 l Business Mirror
Everyone knows that interest is what your money earns as it is used by others. When it is deposited in the bank, they normally pay you an interest for keeping it there, and when you borrow money from say your credit card, you end up paying an interest for using their money. The interest is normally paid on a periodic basis, which in most cases is every month for banks and credit card companies.
What happens when this interest is left in the deposit or unpaid in the credit card? It gets compounded! This is when this interest becomes part of the principal and like the original principal earns interest as well! As a simple example, when you have a deposit of 1,000,000 for 1 year and the bank gave you an interest rate of 12 percent per annum, at the end of 1 year you will get an interest of 120,000, which is 1,000,000 x (0.12) = 120,000. Now, what if you are paid that same 12 percent per annum interest every month and you did not touch that interest and just kept it in your deposit?
In the first month you would get an interest of 10,000, which you calculate by 1,000,000 x (0.01) = 10,000. On the second month your principal is no longer 1,000,000 but is now 1,010,000! Therefore of the second month your interest will now be 1,010,000 X (0.01) = 10,100. As if by some magic you now got 100 more. What happens on the third month? Your principal now becomes 1,020,100 and the interest is you will earn is 1,020,100 x (0.01) = 10,201, which is 101 more than the second month! If you keep on doing this for the whole 12 months or 1 year, the total amount you would have would be 1,126,825 = 1,000,000 x (1.01)^12. An increase of 6,825 more interest due to the effect of compounding!
Compounding interest has a snowballing effect that allows interest to become part of the principal hence enabling the interest to earn interest. Is this good or bad? Well it depends on which side you are on, for the depositor or lender, compounding interest will allow them to get more interest. The effect of compounding interest gets magnified as the interest rate becomes higher, the compounding cycle becomes shorter and the tenor becomes longer. Knowing which side of the equation you are on will enable you to negotiate for more favorable terms to your advantage!
After reading this, you should be able to realize that in a stable interest rate environment, choosing a shorter tenor placement and renewing over and over again will give you a higher effective interest rate. However, when the interest rate for longer tenors is higher than shorter one, you need to take into account if the compounding effect will be enough to make up for the lower interest rate. In situations when interest rates are headed lower, you may want to lock in your placement rates at a higher interest rate. Hopefully, learning about these things will help you manage your finances better.
***The views expressed herein are his own and do not necessarily reflect the opinion of his office as well as FINEX. For comments, email georgechuaph@yahoo.com. Photo is from Pinterest.