Accrued interest is used when an investment pays a constant amount of interest, which can easily be prorated over short periods of time. Bonds are good examples of investments where accrued interest calculations are useful.
Compound interest refers to an investment that earns interest which is then added to the principal balance, and the interest is then paid on the original principal. more accrued interest. In other words, compound interest payments increase over time.
In a nutshell, accrued interest refers to interest that has accrued, but has not yet been paid. For investors, this is usually used in reference to fixed income investments such as bonds, which generally pay interest every six months.
For example, let’s say you have a bond with a face value of $1,000 and a coupon rate of 6%. By dividing this rate by 12, we find that the monthly interest rate is 0.5%. So, if two months have passed since the last interest payment, the value of two months of interest would be 1% of face value, or $10.
This is useful to know, especially if you are buying or selling a fixed income investment. As part of the sale, the buyer must pay the price of the deposit more interest accrued since the last interest payment.
Compound Interest: How Investors Get Rich
Compound interest means that interest accumulates over time, not only on the principal, but also on the interest that was previously earned.
The opposite of compound interest is simple interest, which is the type of interest paid by bonds and some other fixed income investments. For example, a bond with a face value of $1,000 and a coupon rate of 5% will pay $50 per year for the life of the bond, no more, no less.
On the other hand, compound interest allows for exponential growth. Let’s say you have a five-year, $1,000 CD that pays 5% interest, compounded annually. (Note: Most CDs are compounded daily or weekly, but we’ll use the annual example to keep things simple.) In the first year, the CD would pay $50 in interest, which would then be added to the principal.
In the second year, interest would be paid not only on the initial principal of $1,000, but on the full balance of $1,050. So instead of $50, the second interest payment would be $52.50, bringing the account balance to $1,102.50. In fact, at the end of five years, the CD would be worth about $1,276, slightly more than the $1,250 it would reach using simple interest of $50 per year.
Where compound interest gets really interesting is in high-potential investments, such as stocks, compounded over long periods of time.
Historically, the stock market has produced average annual returns of around 9.5%. So if you invest $10,000 in stocks for 30 years, that could go up to over $152,000 based on that historical rate. This is the power of compound interest for investors.
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