“Simple is as simple does” said Forrest Gump some years ago. So what is “simple interest” and how does it compare with “compound interest”? This back to the basics article will give you the overview.
Simple interest rates are a different method to calculate rates of return. Simple rates are used in stocks, limited partnerships, and mutual funds. Unless stated otherwise, most mutual funds use simple interest rates.
With simple rates, your principal does not compound as illustrated in the Rule of 72. With simple rates the investor earns 100% each time the principal doubles. Check out this example from Left-Brain Finance for Right-Brain People, pg 24:
If you invest $1,000, then six years later sell the investment for $2,000, you made a $1,000 profit or 100% of your money.[...][T]he total profit divided by six (number of years) gives the annual yield of 16.7% (100 / 6 = 16.7%). Or, the profit per year, $167, can be divided by the principal, $1,000, to get the same, 16.7%.
The 16.7% simple yield used in this example is equivalent to a 12% compound yield. That is, in six years, $1,000 earning 12% compound interest grows to $2,000; and, in six years, $1,000 earning 16.7% simple rate of return also grows to $2,000.
Most investments calculate yields using the simple method. Be realistic making comparisons and don’t think the simple rate is always better because it is higher.
For more Forrest Gump-isms on making money, check out this blog entry, “The Forrest Gump Guide to Becoming a Gazillionaire”.
