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Stan Cowan
Stan Cowan has worked in the financial industry for over eight years and is currently VP of marketing for Boeing Wichita Credit Union. His education includes a BBA and MBA from Wichita State University. He also teaches part-time for the Wichita branch of Baker University. Stan can be reached at (316) 651-5169 or scowan@bwcu.org
Banking & Finance
2003-03-01 13:26:00
Different types of interest
ANSWER:  There are two types of interest and interest calculations.  They are simple interest and compound interest.  Both are expressed as percentages.  I will illustrate the difference with an interest-earning deposit.A person makes a deposit with a financial institution, which promises a certain rate of interest per year, paid after specified intervals of time. With simple interest, the amount of the deposit remains the same, and the amount of interest is paid to the depositor at the end of each interval of time. With compound interest, the amount of the deposit rises because the interest is added to the deposit at the end of each interval of time.For example, suppose the deposit is $1000, the rate of interest is 6 percent per year, and the payment intervals are quarterly.  If this is simple interest, the financial institution will pay the depositor $15 at the end of each quarter, for a total of $60 interest earned for the year (6 percent of $1000). The total assets of the depositor after one year will be $1060.If this is compound interest, the payment will still be $15 at the end of the first quarter, but the interest will be added to the deposit, making the deposit now $1015. At the end of the second quarter, the interest will be calculated using this larger amount and will come to $15.225, which will be added to the deposit, making the new total $1030.225.The interest paid at the end of the third quarter will be calculated using the second-quarter total, and will come to $15.453375, which will again be added to the deposit, for a total of $1045.678375.At the end of the last quarter, the interest will be calculated based on the third-quarter amount, and will come to $15.685175625. Thus the total assets of the depositor at the end of the year will be $1061.363550625.Of course, financial institutions do not keep track of these fractions of cents, and interest payments are rounded to the nearest cent. This means that the actual amounts paid are not the numbers shown above. Instead, the second interest payment will be $15.23, the third will be $15.45, the fourth will be $15.69, and the total assets will be $1061.37. Notice that with compound interest, the depositor's assets at the end of the year are $1.37 more than with simple interest. This is because during the last three quarters of the year, the depositor is earning interest on the interest previously earned.Note: All the formulas below assume that interest earned is computed exactly, and not rounded at all. The effect of rounding is usually an extremely small amount over the course of many payments.
 
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