It may earn simple
interest,
which means the interest is
figured on your principal alone
It may earn compound
interest,
which means the interest you
earn on the investment also earns interest
Doing the math
The way the interest is calculated
will affect the yield,
or what you earn on your investment.
The more frequently the interest is compounded, the higher
the yield, or the rate of return on your investment.
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 a total of $1,250
in interest. In this case the interest rate and the yield
are the same — 5% per year.
But the same $5,000 investment paying
5% interest compounded annually for five years would produce
a total of $1,381.41 in interest. Because you’re earning
interest on your interest, the yield — an average of
5.52% per year — is higher than the interest rate.
