Real Estate Concepts: Compound Interest

Every investor needs to know the value of his portfolio at different periods.  Before starting a venture, he wants to know how much will he earn after a period of time.  The Rate on Investment (ROI) is a measure of income or profit.  It is a gauge of cash or potential cash produced by an investment or the cash loss because of an investment. 

Compound interest is the theory pf adding accumulated interest or earning back to the principal.  Other terms used interchangeably with compound interest rates include annual percentage rate, effective annual rate, and effective interest rate.  Compound interest generally prevails in finance and economics.  It is worth mentioning that there was time in human civilization when compound interest was considered as the worst type of usury.  Compound interest was extremely condemned by Roman law in addition to common laws of other countries.

The word “yield” signifies a rate of return that is derived from compounding, reinvestment, or varying market value of a security.  Two factors have great effect on compounding: the periodic interest rate; and the frequency with which the interest is compounded.  The frequency of compounding is generally annual, semi-annual, quarterly, monthly, or daily.  The periodic interest rate is simply the interest to be charged for each period.  A nominal interest rate is an annual rate that has not been “adjusted” for compounding.  For example, if Mr. Li invested in real estate in Hong Kong in January of 2008 with an initial capital of $10,000 that pays a yearly interest rate of 4% that is compounded quarterly then the table below shows the value of his property at a given quarter

The yearly interest rate is 4%, which also represents your nominal rate since it has not been adjusted.  To obtain the periodic rate for quarterly compounding, divide 4 (interest) by 4 (number of quarters in a year) and you get 1 or the quarterly ROI.

When an interest is earned by an investor it is converted into a capital.  The process of compound interest entails reinvestment of capital; the dollar earned for each quarter is reinvested.  On March 2008 Mr. Li earned $100 which was added to his initial investment making his new capital for June 2008 $10,100 and so on. 

Checking how often interest is compounded is a smart thing to do before deciding to invest in any real property.  Obviously, the more frequent it compounds, the faster you reach your financial goals.  These are basic information you have to know if you seriously intend to maximize the full potentials of your investment.  Also, it can save you with so much troubles and headaches in the future.
real_estate_compound_interest