The low interest rate environment that we’ve been operating in for a while now sees no sign of abating. The continuation of these market conditions has resulted in two things. One; great interest rates are available from a borrower’s perspective, and two; more pressure for lenders to offer competitive rates.
With that in mind, how do we make our investment funds work harder for us? One answer could be: Compound interest.
The best place to begin building an understanding of how compound interest works for investors is by taking a look at the different ways that interest is ultimately paid to an investor.
How is interest paid to an investor?
Interest on any investment is paid to investors one of two ways;
- Into your designated bank account at a regular period decided by the provider.
i.e. monthly, quarterly etc. - Added back onto your investment and paid at the end of the investment term. This would be called Compounding.
The majority of Southern Cross Partners investments are paid to the investor’s bank account on a monthly basis. This is because we process the borrower’s interest payment when it comes in and divide that amount amongst the investors.
What is Compounding and how does it work?
Compounding Interest describes the process of adding the allocated interest portion earned back onto the principal investment amount.
The principle investment amount is the sum initially invested.
At Southern Cross Partners, interest is calculated daily and, with investents that are designated as compounding, instead of being paid directly to the investors bank account, once a month, it is added back onto the investor’s principal investment (the monthly amount will vary depending on a 30 day or 31-day month, or 28/29 in February).
Reinvesting interest by way of Compounding Interest effectively enables an investor to earn interest on their interest. The total amount of interest earned will be paid along with the principal investment sum when the loan is repaid.
So what do investors prefer?
The feedback we have is that a large portion of our investors prefer a monthly payment as it helps to maintain regular cashflow. As one of our investors astutely put it;
“it allows us to have a few extra flat whites in a week!”
However, from time to time some of our investments offer Compounding Interest and other investors recognize this could be a way of boosting their overall interest. (This feature is available only on specific investments that are identified as such on our web listings )
Why would a loan offer compounding interest?
Firstly, a quick recap as to how our investment options are created.
A borrower who has a need for finance that may not fit a regular retail bank would most likely approach a mortgage advisor to assist. The mortgage advisor then sends the application for finance for us to assess.
In some of these cases, the borrower requests for their interest payments to be added to the loan amount or capitalised, instead of making regular monthly payments, therefore there are no regular interest payments to pass onto the investors.
When do compounding interest loans make sense for the borrower?
A loan that offers compounding interest would most likely be for construction of speculative building projects or loans of a development nature such as multi-property subdivisions.
It can also be useful for borrowers who are looking for bridging finance who are essentially paying a mortgage for two properties while they wait for one to sell.
The interest they owe is paid at the end when the loan is repaid so assists the borrower with cashflow during their project.
Is compounding interest the best option for an investor?
As we have described choosing a compounding investment has its benefits, but it may not suit everybody.
There are a range of options available so you don’t have to have all of your eggs in one basket. In fact, some of our investors split their investments up to include a compounding element, as well as a monthly payment.
In reality, you will be the best person to understand your cashflow requirements, and whether or not you’re in need (or simply prefer) the monthly cashflow injection, or are in a position to reinvest any interest earned for a higher reward at the end of the loan term.
Of course, we’re more than happy to help and advise on the difference between the two. If you have any questions about Southern Cross Partners investments, please get in touch!
