Compound Interest Basics

The Idea of Compounding

Compound interest is something consumers hate. With compound interest, not only are you charged interest on the principle, which is the money you borrow, but you are charged interest on the interest. The interest compounds on itself, making you pay more and it is something most people could do without.

Compound interest has actually been with humanity for quite awhile, dating back 2,000 years to the days of the Roman Empire. Back then, compound interest was regarded as the worst type of usury and it was condemned under Roman law. As well, the Qur’an and the Bible both contain references to compound interest. In the Qur’an it says “O ye who believe. Devour not usury, double and quadrupling. Observe your duty to Allah, that ye may be successful.” In the Bible, there is a reference to it in Leviticus 25:36-37 which reads “Take no usury or interest from him; but fear your god, that your brother may live with you. You shall not lend him your money for usury, nor lend him your food at a profit.”

In 1613, Richard Witt wrote Arithmetical Questions, which is considered a landmark book on compound interested. Completely devoted to the subject of compound interest, it was in sharp contrast to other books because most devoted only a chapter to the concept.

Enough about the history of compound interest though, how does it work? Well, if you take out a loan that has interest compounded on a monthly basis then it will work like this:

The loan is for $1,000 and you have one percent interest per month, which means that at the end month one you owe $1,010, and at the end of the second month you owe $1,111 and so on. So, the interest from month two is being added to the principle you owe, plus the interest you owe from month one. Naturally, this can quickly get out of control, especially when you are dealing with very high interest rates.

Most people prefer to see interest as a yearly percentage and for this reason many governments force banks and other financial institutions to disclose the equivalent total interest for the year. So, for one percent interest per month, the annual percentage rate would be 12.68 percent. This prevents people from being misled into thinking they are only paying one percent interest on their principle.

Compound interest should not be confused with simple interest, which is interest that is not compounded on top of it. Sadly, simple interest is not used very often. Compound interest is used quite a bit in finance and economics and if you have a credit card, you are paying with compound interest.

It is important to look at the laws dealing with usury to ensure that you are not becoming a victim of it through compounding interest. You want to ensure that when you get a loan, you are not going to be paying interest on interest to a degree that could cause you to default on the loan itself.