Investing - Definitions 104

What is the difference between simple and compound interest?

Simple interest is an annual return that is paid out and not reinvested.  For example, let’s say you earn 5% on a $100,000 investment.  Over three years, it would look something like this:

·         Year 1 - $100,000 + $5000 interest

·         Year 2 - $100,000 + $5000 interest

·         Year 3 - $100,000 + $5000 interest

Compound interest is when the annual return is added to your original investment and continues to earn income.  Over 3 years, a $100,000 investment earning 5%, but compounded annually, would look something like this:

·         Year 1 - $100,000 + $5000 interest

·         Year 2 - $105,000 + $5250 interest

·         Year 3 - $110,250 + $5513 interest

While the difference is small initially, over time it can really add up:

·         10 Years                Simple Interest: $50,000               Compound Interest: $62,889

·         30 Years                Simple Interest: $150,00               Compound Interest: $332,194

·         50 Years                Simple Interest: $250,000            Compound Interest: $1,046,740

As you can see, time is a key element related to investing and compounding. If your investments are compounding at a rate that roughly doubles your investment every 10 years, then you want to have as many decades as possible to allow as many ‘doublings’ as possible. It is one of the easiest ways to put your money to work for you!