Simple and compound interest allow your money to work for you by earning additional income. Although both types of interest earn you money, compound interest potentially earns you more. However, if you borrowed money for an investment, the interest on the loan works against you in the same way.
Simple interest investments offer regular interest payments, but only the invested capital earns interest. Bonds that make regular coupon payments are an example of simple interest investments. As an example, a $1,000 bond that makes annual coupon payments of 6 percent pays you a total of $60 per year. However, these payments may span four quarterly payments of $15.
Calculating Simple Interest
Simple interest is the easiest type to calculate. Multiplying the annual percentage rate by the investment amount produces the annual interest. If the investment offers numerous payments per year, divide the interest earned by the number of annual payments. In the example, multiplying $1,000 times 6 percent, or 0.06, calculates annual interest of $60. Dividing $60 by 4 calculates a quarterly payment of $15. If the investment spans multiple simple interest payments, simply multiply by the number of payments. Continuing with the example, if you held the investment for three years, multiplying $60 times 3 calculates the three-year interest of $180.
In contrast with simple interest, the amount earned from compound interest also earns interest. This compounding effect can significantly increase your earnings or the amount owed on a loan. Anytime interest money is reinvested, it earns compound interest. Savings accounts are a good example, assuming you keep the interest in the account. As an example, if a savings account’s $1,000 balance earns 0.5 percent interest per month, you earn $5 the first month, but $5.03 the next month. These small increases add up to potentially large earnings.
Calculating Compound Interest
To calculate compound interest, add 1 to the periodic interest rate and raise the result to the number of compounding periods. Then, multiply the figure by the investment amount. In the example, if the savings account compounded for 12 months, raising 1.005 to the power of 12 and multiplying by $1,000 calculates the new balance of $1,061.68. Had the account grown with simple interest, the balance would only be $1,060, calculated as 1 plus 0.005 times 12 periods and multiplied by $1,000.
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