Part E Reading

Interest

When it comes to savings, interest is what it’s all about.Interest is what a borrower pays a lender for the use of the lender’s money.

When you deposit money in a savings account, a money market account, or a certificate of deposit, you’ll lending the bank your money.The bank uses that money to make loans — essentially, borrowing money from you and paying you interest for the right to use your money to lend to someone else.

Of course, the bank then charges that loan customer an even higher interest to recover the interest it’s paied to you.Interest is calculated as a percentage of the amount of the principal.

Interest can get complicated, especially when the terms “rate” and “yield” are involved.The difference between rate and yield is determined by how frequently interest is paid, and how it is paid.

Interest is calculated by multiplying interest rate, by the amount invested and by the fraction of a year the money is invested.When an investment pays interest annually, its rate and its yield are the same.The more frequently interest is paid, the higher the yield.That’s because the interest payment is credited to the principal and it starts earning interest along with the invested principal.

For example, if you have a CD with a 5% nominal rate and the interest is paid annually, a $ 10,000 investment will earn $ 500 in interest.If the 5% CD is paid interest semiannually, the six-month interest payment is $ 250.The $ 250 starts earning interest and earns $ 6.25 during next six months.That’s what compounding interest is all about.

The first CD earns $ 500 in interest after a year and the second CD earns$ 506.25 in interest.The rate and yield on the first CD is 5%.The rate on the second CD is 5%, but its yield is 5.06%.If interest is paid daily, the rate would be 5% and the yield would be 5.13%.These yield computations assume that the interest is reinvested in the CD at the CD’s nominal rate.