17.1: K1.01- Simple and Compound Interest

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Finance: Simple and Compound Interest

Questions Explored:

What is the difference between simple and compound interest?
I want to deposit a lump sum of money into an account earning interest and leave it there. What will I have in the future?
What lump sum should I deposit into an account earning interest in order to have a certain future value?
What happens to my credit card balance if I don’t pay any of it for a period of time?

Terms:

Principal – initial amount of the investment or loan
Interest – amount paid to you by the lender for investing with them, or, the fee you pay for borrowing money
Simple interest – interest paid only on the original principal
Compound interest – interest paid on both the original principal and any interest that has been added to the original principal
Annual percentage rate (APR) – % of interest earned or owed each year; may need to be divided up for smaller time periods (i.e. monthly, quarterly, etc.), APR does not take compounding into account
Compounding period – period at the end of which interest is computed
- o Annually = once a year
- o Semiannually = twice a year
- o Quarterly = four times a year
- o Monthly = twelve times a year
- o Daily = 365 times a year (was 360 in the past before computers were readily available to make math easier for the banker)
Savings accounts – accounts into which you deposit money
- o Currently savings accounts have a very low interest rate
- o Standard savings accounts, money market accounts, and CDs (certificate of deposit) are a few different types of savings accounts with different interest rates and withdrawal restrictions.
FDIC – (Federal Deposit Insurance Corporation) guarantees safety of bank deposits currently up to $250,000 per depositor per bank (as of 2016)
Bonds – when you purchase a bond, the bond issuer is in debt to the bond holder and pays the bond holder interest on the bond and/or repays the principal later to the holder
- o The bond holder is the lender and has loaned the bond issuer money, who is now the debtor.
- o There are many types of bonds: Treasury bonds, corporate bonds, municipal bonds, etc.
- o Bonds may have a fixed or variable interest rate.
- o Interest may be simple or compound.
- o Bonds may or may not be inflation-linked.
- o Bonds may or may not have tax advantages
- o Bonds may be low or high risk
Credit card – system of payment that allows someone to purchase goods or services with the promise that the money will be repaid
Annual percentage yield (APY or effective annual yield or effective yield or yield) – actual percentage by which a balance increases in one year, slightly different than the APR since it takes compounding into account

Rules

Simple interest: The amount of interest earned is the same percentage of the original principal every year.

Compound interest: The amount of interest earned in each time period is computed on the accumulated amount of money in the account at the beginning of that time period.

Annual Percentage Yield: The annual percentage yield of an investment is computed by finding the relative change from the initial balance to the balance at the end of the same year.

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