The Concept of Simple Interest and Compound Interest and How They Affect the Results of Investment
Interest is what an investor earns in a bank savings account, certificate of deposit, bond or other interest-bearing financial instrument. Interest is also the cost of borrowing money, such as the interest on a term loan or an outstanding credit card bill. The two basic interest calculation methods are simple interest and compound interest. For the same interest rate, the compound interest method means better investment results.
Other People Are Reading
-
Simple Interest
-
The formula for simple interest is P x R x N, where "P" is the principal or original amount of the loan or investment, "R" is the interest rate for one period and "N" is the number of periods. The future value of an investment is the original investment plus the accrued simple interest. For example, if an investor deposits $1,000 in a savings account paying 2 percent interest annually, the simple interest accrued and the investment value after one year are $20 ($1,000 x 0.02 x 1) and $1,020 ($1,000 + $20), respectively.
Compound Interest
-
The formula for the future value of an investment using compound interest is P x (1 + R)^N, where "P" is the principal, "R" is the interest rate and "N" is the number of periods. If the interest compounds more frequently than annually, "R" is equal to I/M and "N" is equal to MT, where "I" is the annual interest rate, "M" is the number of times the interest compounds per year and "T" is the length of the investment term.
Continuing with the example, if an investment compounds annually at 2 percent for seven years, the future value of a $1,000 investment is about $1,149 [$1,000 x (1 + 0.02)^7 = $1,000 x 1.02^7 = $1,000 x 1.14868 = $1,148.68]. If the interest compounds monthly, the interest rate for each period is 0.17 percent (2 percent / 12), the total number of periods is 84 (12 x 7) and the future value is about $1,150 [$1,000 x (1 + 0.0017)^84 = $1,000 x 1.00017^84 = $1,000 x 1.1501 = $1,150.14].
-
Investment Impact
-
The simple interest formula applies to the principal amount only. It does not include the effect of accrued interest. The compound interest formula applies to both principal and accrued interest. Compounding generates more interest income over comparable periods and interest rates.
For example, the accrued interest on a $100 investment at 5 percent simple interest over five years is $25 ($100 x 0.05 x 5) and the value of the investment after the five-year period is $125 ($100 + $25). However, if the same interest rate compounds annually, the value of the investment is $127.63 [$100 x (1 + 0.05)^5 = $100 x 1.05^5 = $127.63].
Considerations
-
In addition to checking and savings accounts, investors can choose from several interest-bearing products, such as U.S. Treasury bills, certificates of deposit and corporate bonds. The interest rates on these products are a function of the issuers' credit risk. For example, U.S. Treasury bill rates are lower than corporate bond rates because investors regard the U.S. government as a low-risk issuer.
-
