If someone asks you if you would prefer $1,000 today or $1,000 next year, your answer should be “Give me $1,000 today!” You understand that if you receive $1,000 today, you can invest that money right away make it work for you now instead of next year. However, an equally important consideration for all couples when selecting investments is the chance to earn compound interest and compound earnings -- and to know the difference.
If your earnings on a two-year investment was a matter of simple interest, you could add the cash flow from the investment you're to receive one year from now to the cash flow you're to receive two years from now to determine your actual return on the investment. However, if an investment's future value is determined by compound interest, time becomes a multiplier of the interest you'll earn. The future value of your investment will be the sum of the principal you invest and the compound interest, calculated on the sum of the principal and accumulated interest on that principal. The rate at which your principal will grow is determined by the rate at which interest is added to the principal. Although interest is frequently calculated on an annual basis, the terms of any investment are determined by your deposit or investment agreement.
Compound Interest Example
Compound interest accrues on both the past, unpaid, accrued interest and the investment's principal. Assume you invest $1,000 at 10 percent interest, compounded quarterly for 12 months, or four quarters. The value of the investment is determined by calculating the compound interest earned for each quarter and adding that figure to the value of the principal at the beginning of the quarter. The original investment of $1,000 is multiplied by 10 percent -- which equals $100 -- which is then multiplied by 1/4 to equal $25. As a result, the value of the investment at the end of the first quarter is $1025, or $25 interest plus $1,000 principal. In turn, the value of the investment at the end of the second quarter is $1050.62 -- calculated by multiplying the $1,025 first quarter valuation by 10 percent to equal $102.50. This value is then multiplied by 1/4 to equal $25.62, which is added to $1,025 to determine the second quarter investment valuation of $1,050.62. This calculation is repeated for the two remaining quarters to determine the investment's total compound interest of $103.80 and year-end valuation of $1,103.80.
Compound earnings is equal to the interest or dividends paid on an investment in addition to any increase in the value of the related investment, such as bonds, stock or real estate. For example, a brokerage firm may advertise that a stock mutual fund earned 24 percent in a particular year. This does not mean that investors were paid 24 percent interest on their investment. Nor does it necessarily mean that the value of the shares held in the fund increased by 24 percent. Instead, the 24 percent earnings may represent both an increase in the share price as well as a dividend distribution.
The size of an investment's return is not simply a factor of the dollar value of the initial principal invested. It also depends on the rate at which the investment increases and the time period during which the principle is invested. In turn, the rate at which an investment increases is affected by the type of investment. For example, a certificate of deposit will likely pay a fixed compound interest rate in exchange for an investment of principal for a fixed time period. However, if you buy stock, the compound earnings of your investment might be determined not only by the market value of the stock but also the payment of dividends that take the form of cash, stock or property.
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Billie Nordmeyer works as a consultant advising small businesses and Fortune 500 companies on performance improvement initiatives, as well as SAP software selection and implementation. During her career, she has published business and technology-based articles and texts. Nordmeyer holds a Bachelor of Science in accounting, a Master of Arts in international management and a Master of Business Administration in finance.