What Is Compound Interest?
In commercial real estate finance, understanding the difference between "simple interest" and compound interest is the difference between a profitable investment and a catastrophic default.
Simple interest is calculated only on the principal amount. If you borrow $100,000 at 10% simple interest per year, you owe $10,000 in interest every single year. After three years, you owe $130,000.
Compound interest is "interest on interest." It is calculated on the principal plus whatever interest has already piled up. If you borrow $100,000 at 10% interest compounding annually, in Year 1 you owe $10,000 in interest (Total: $110,000). In Year 2, the 10% is calculated on the new $110,000 total, meaning you now owe $11,000 in interest (Total: $121,000). In Year 3, the 10% is calculated on $121,000, adding $12,100 (Total: $133,100). The debt accelerates exponentially.
Compound Interest in Real Estate Loans
Most standard 30-year residential mortgages are amortized with compound interest baked into the math. In the first five years of a 30-year mortgage, almost your entire monthly payment goes toward paying off the compound interest, while your actual loan balance barely decreases.
However, compound interest becomes extremely dangerous in "negative amortization" or "hard money" commercial loans. If a developer takes out a $5 million loan to build a condo, but the loan defers all payments until the building is finished, the interest compounds daily or monthly. By the time the building is finished two years later, the developer might owe $6.5 million due to the brutal mathematical acceleration of compounding.
Related Terms
- Mortgage — The primary real estate loan driven by compounding math
- Promissory Note — The contract that explicitly dictates how the interest compounds
- Equity — The property value that compound interest slowly eats away if payments are missed
Barnes Walker Commercial Lending
Barnes Walker's finance attorneys assist commercial developers and private lenders in negotiating complex promissory notes, meticulously reviewing amortization schedules and compounding clauses to ensure our clients understand the exact, exponentially accelerating cost of their capital. Request a legal inquiry for assistance.
Reviewed by the attorneys at Barnes Walker, Goethe, Shea & Robinson, PLLC