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

## Compound

The concept of capitalization is quite simple, but its effects are surprising. Compounding 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 charges for the second year will be more than $10,000. The total debt on which interest charges will accrue in year two is $110,000. Therefore, the interest expense for the second year is 10% of $110,000, or $11,000.

## Examples

The compounding effect is more pronounced if interest costs are assessed frequently. Consider two loans, one with 1% monthly interest charges and one with 12% annual fees, both with a starting balance of $100,000. 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) raised 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) raised to the power of 12), or $112,683.

## Effect on invoices

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

## other considerations

The effect of capitalization on invoices can be even greater if the agreement between you and the lender includes additional penalties or other clauses. If the contract states that payments not received within 60 days of the due date result in an additional $750 late fee, which is also subject to interest charges, the loan will grow at an even faster rate after 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 may be 1%, this figure may increase to 1.5% per month after 30 days.