Tuesday, 20 September 2011

Compound Interest

Before we get to compound interest, lets briefly discuss simple interest.

Principle bears interest at the end of each period. The period for most investments is one year. For our discussions today, we will only discuss interest being paid once per period or once per year. Interest is a fee that is paid on borrowed capital. Whether borrowing from a bank, credit card company or an investor, borrowing incurs a cost. Interest is much like rent.

Simple Interest

$10,000 is borrowed at 10% interest for 5 years. This is how simple interest would be calculated.

At the end of each year, interest of $1,000 ($10,000 * 10% = $1,000) is paid to the lender. At the end of 5 years the borrower would have paid $5,000 ($1,000 * 5 = $5,000) in interest and also returned the principle of $10,000. The lender lent the principle of $10,000 and was returned the principle and interest of $15,000.

Compound Interest

There is one main difference with compound interest and that is that the earned interest is reinvested each time it is paid. For example, at the end of year 1 $10,000 earns $1,000 in interest. The principle now rises to $11,000. At the end of the second year, the interest is calculated on the new value of $11,000. This makes for interest of $1,100 for year 2. The following 3 year each compound as well. Take a look at the schedule below to see what happens during the remaining 3 years.

As you can see, a principle of $10,000 would have gained $5,000 with simple interest and $6,105 with compound Interest.

Comparing Simple and Compound Interest

When evaluating an investment, be sure to know which type of interest is being advertised.  Simple interest returns less than compound interest.

To illustrate this we will use a simple rate of 20% and compare it to the EQUAL compound rate of 14.87%. Both rates return $20,000 after 5 years. 

Once again, the reinvested growth raises your investment principle each year thus creating greater returns.  Investments returns that span a number of years can be shown either way.  Knowing which one you are seeing is essential for an apples to apples comparison.

For simple and complex information on compounding formulae, visit Wikipedia.org.

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