K1.01: Simple and Compound Interest

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.