Interest Rates and Compounding Interest

Understanding interest rates and their effect on the new personal residence you want to purchase is part of the process of becoming “business fit”.  If you are considering purchasing income property, understanding how mortgages work and the importance of interest rates is critical to successful real estate investing. 

Albert Einstein evidently thought that the effect of compounding interest was so dramatic, that he referred to it as the “8th Wonder of the World”.  He said, “He who understands it, earns it… he who doesn’t… pays it”.

Compound interest is interest computed on the accumulated unpaid interest as well as on the original principal.  Compounding interest involves adding interest to the sum of the principal and any previous interest in order to calculate interest in the next period, or interest calculated on both the principal and the accrued interest.

Understanding basic mathematics is crucial when investing.  I know most of us think we understand the concept of interest, but when it is applied to different investment possibilities the impact and results vary dramatically.

Leverage and compounding interest are probably the two best keys to real estate investing. If you are saving money compounding interest will greatly benefit you. If you are borrowing money it can be terrible.

Using leverage, or borrowed money, when purchasing real estate allows you to make a larger investment than you would normally be able to.  Leverage produces much greater returns on the dollars you invest, but involves paying interest.

Educating yourself on the various types of real estate mortgages can be of great value to the success of your investing.  Do you really know the impact of interest only mortgages verses (30) year or (15) year fully amortized mortgages?  Take the time to ‘pencil out’ an example of the mortgage you presently have on your home and look at the balance of principle owed after 5, 10,15, and 20 years.  You may be shocked.  Obviously, you pay your loan off in half the time with a 15 year mortgage verses a 30 year mortgage.  See what the balance owing on a 15 year loan is after 8 years verses 8 years on a 30 year loan.  Just think, if someone told you that you didn’t need to make a mortgage payment on your home for the next 15 years, wouldn’t that put a smile on your face?

Understanding various forms of interest and their effects can be very helpful.  When you combine the power of leverage with compound interest, we know from both experience and basic math that you can make phenomenal returns.  Real estate investors who understand the true importance of “interest” on their investments benefit the greatest.

This article was originally written for and appears in the San Francisco Examiner. Eric Ruxton and Larry Aikins are the owners of Terrace Realty Inc. and Terrace Associates Inc., in Redwood City. Terrace has been in business for  60 years and in addition to being an independent Brokerage Company, also owns and operates rental properties.