The "com" in compound also means a bit more "com"plicated. Compound interest results in interest being calculated not only on the original principal but also interest on the accumulated interest. As a real estate agent working with real estate investing clients, if compound interest is a factor, it's important that you know how to calculate compound interest. Of course, that's easy with an interest rate calculator, but there's no substitute for at least knowing the basics and the effects of compounding.
- Difficulty: Easy
- Time Required: 10 Minutes
- Using a simple time charting method: Let's look at a $100,000 principal amount with a 6% interest rate, compounded annually for three years. Year 1
- $100,000 X .06 for one year is $6000 interest.
- Year 2
- Now we have $106,000 X .06 for the second year is $6360 interest.
- Year 3
- Starting with $112,360 accumulated X .06 = $6742 interest.
- At the end of year 3, we have $119,102. As you can see, compound interest definitely beats simple interest for return.
- As a mathematical formula: This is a straight formula, but a bit trickier as we need to raise a number by a power.Principal X (1 + Periodic Rate) ^ Number of Periods = Future Amount
- $100,000 X (1 + .06) ^ 3 = Future Amount
- $100,000 X (1.06 x 1.06 x 1.06) = Future Amount
- $100,000 X 1.19 = $119,100 rounded off.
- Visitors who have found this article helpful are also reading about calculating capitalization rate.
Getting on the Other End of Interest
This discussion has all been about paying interest, your cost for using someone else's money. It's a valuable leverage tool, especially mortgages in real estate. One of the greatest things about real estate investment is that there are many different ways to invest and make profits.
You can buy mortgages. If you look into it, you would probably be surprised how many homes are sold each year with owner financing. Many will be first mortgages, while others will be seconds. The point is that these aren't mortgage notes held by banks. Instead, they are individuals who sold their home and financed it for the buyer in whole or in part.
Why would they do this? It may be the only way they could get a willing buyer who was short of cash into the home. There are also tax advantages in avoiding or delaying capital gains taxes by financing the home for the buyer.
So, we have all of these past property owners out there who have sold their homes and take a mortgage in lieu of cash. At some point, they may be tired of collecting payments, or maybe they need to cash out for other reasons, such as medical expenses. The point is that they want or need to get the cash out of their note rather than continue to collect mortgage payments.
An investor can buy the note, which makes them the mortgagor who is collecting payments with interest at a monthly profitable cash flow. Of course, in most cases, there will be a discount applied, and it will often be based on current interest rates compared to the rate of the note.
If the investor could get a better rate elsewhere, they would take it. So, when mortgage rates are running 5%, if the note is at 4%, the investor would buy it at a discount mathematically calculated based on the length of the note. Since mortgages are more secure than other types of loans, there is a lot of this note buying going on. There is a lot more to it, so do your research.