The interest income you earn on cash investments may be calculated in two ways:
It may earn
simple interest,
which means the interest is figured on your principal alone
It may earn
compound interest,
which means that the interest you earn on the investment also earns interest
How the interest is calculated will affect the
yield,
or the rate of return on your investment. The more frequently the interest is compounded, the higher the yield.
Doing the math
For example, if you had $5,000 in an account that paid 5% annually in simple interest for five years, you'd earn $250 a year, for total interest of $1,250. In this case the interest rate and the yield are the same — 5% per year.
But the same $5,000 investment paying 5% compound interest for five years would produce a total of $1381.41 in interest. Because you're earning interest on your interest, the yield — 5.52% per year — is higher than the interest rate.
However, unless you're investing a large amount of money, it's probably not worth chasing after small differences in yield, since the costs of research and transferring your money may outweigh the nominal increase in earnings.
$5,000 invested at 5% interest
Compound (annually)
Simple
Start
$5,000.00
$5,000.00
After 1 year
$5,250.00
$5,250.00
After 2 years
$5,512.50
$5,500.00
After 3 years
$5,788.13
$5,750.00
After 4 years
$6,077.53
$6,000.00
After 5 years
$6,381.41
$6,250.00
Growth
27.6%
25%
Annualized rate
5.52%
5%
Market rate
The interest rates that
banks pay on their CDs and money market accounts
reflect the current market rate. That rate,
in turn, is based on what’s known as the
federal funds rate, which is the rate banks
charge each other to borrow money overnight.
The Federal Reserve determines the federal funds
rate as part of its effort to keep the U.S.
economy growing at a reasonable pace.
