Personal Finance Tip of the Day

In finance, interest can be viewed in two ways: The interest given to a person on money "loaned to" (deposited in) a bank or financial institution, or as a fee (payment) for borrowing or lending money, most often based on a percentage of the requested amount. The two most common types of interest are simple and compound. (For more information on interest, see "Everyday Math.")

In terms of a savings account, the interest is usually compounded, which means that any interest earned is reinvested, or compounded, to generate even more money, and thus increase future interest. Take, for example, a person starting with $1,000 in a money market fund earning 5 percent per year with quarterly interest payments (or the person gets 5 percent divided by four, or 1.25 percent per quarter). After one year, the $1,000 has grown to $1,050.95, making the compound interest rate actually 5.095 percent--not 5.00 percent--because interest was also paid on the accumulated interest for each quarter. (An interest of 5 percent only is called the simple interest rate; but most banking institutions pay compound interest on savings.)

Simple and compound interest are both used in borrowing and lending. With simple interest, the interest is paid strictly on the amount of the initial principal (original amount borrowed or lent), which is usually represented by the formula: a(t) = a(0) (1 + rt), in which a(t) is the sum of the principal and interest at the time t for a constant interest rate r.

Compound interest has a more complex formula. This type of interest is calculated not only on the initial principal, but also the interest accumulated (or accrued) over time. For example, a person purchases a home for $250,000 and pays $50,000 as a down payment. The remaining $200,000 is taken out as a loan at 8 percent interest for 30 years (compounded monthly) with equal monthly payments.