What Are Some of the Uses of Compound Interest in Business?

The way interest is calculated is an essential factor in generating favorable returns off of financing agreements, and the true rate of interest often differs from the stated rate because of compounding. Compound interest is used in a variety of financial instruments that are commonplace in business. Although the purposes for business loans vary, the interest calculation is similar.

When purchasing a production facility or office building, many businesses choose to finance the transaction and take out a mortgage. The financing agreement usually comes with a stated interest rate and a loan term. However, the stated rate is not the effective interest rate because of compounding. With compounding, interest is charged to the principal and any previous interest already accrued. During the course of a year, mortgage interest is charged at varying intervals, which raises the true rate paid. Mortgage terms significantly impact the amount of interest lenders receive.

Sometimes businesses need to take out loans to keep operations going or to buy additional inventory when cash flow is tight. Hard-money loans provide quick financing and are typically secured using real estate as collateral. The application process and qualification criteria are different compared with traditional business loans and are ideal for companies with poor credit histories. Hard-money loans come with a stated loan term and interest rate, but the interest rate is calculated using compounding. As a result, the true interest rate is far higher than the stated one.

Freight companies or distributors use trucks and other vehicles in their operations to move inventory and serve their customers. Some of the larger trucks require significant cash outlays, making vehicle loans useful. These types of loans resemble personal auto loans with interest compounding at regular intervals. The ultimate cost of a vehicle factors into business decision-making and is an important consideration when choosing to buy a vehicle outright or finance it.

Production facilities and machine shops use heavy equipment to manufacture products. Computer-controlled lathes, mills and other industrial machinery is expensive to purchase. These pieces can be financed, and the interest paid is typically compounded over the loan term. The interest expense can be written off against taxable income, which is an important consideration when deciding to obtain a loan.