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Simple vs Compound Interest

Understanding the difference between simple and compound interest is not hard.

COMPOUND INTEREST

Compound interest is the rate of interest paid on the principal and on the interest previously earned. This can help you to build wealth over time because the interest compounds on top of interest, in addition to the principal.

SIMPLE INTEREST

Simple interest is the rate of interest that you would pay on the principal only. As a borrower, simple interest is better because you’re not paying interest on interest. It’s easier to repay debt with simple interest.

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Interest Rates and Bonds

A fundamental principle of bond investing is that market interest rates and bond prices generally move in opposite directions. When interest rates rise, the cost of bonds typically decreases and the bond’s yield (how much you’ll earn) usually increases. This is true for government and corporate bonds.

INVERSE RELATIONSHIP

A bond’s coupon rate (e.g., interest rate) is fixed when issued. But when interest rates change, the coupon rate becomes more or less attractive depending on how interest rates move. When a bond’s coupon rate is lower than the prevailing interest rate, investors will likely find it less appealing, and the bond’s price will decrease. For example, if a corporate bond has a coupon rate of 3%, but prevailing interest rates are 4%, an investor will pay the amount that generates more than a 4% yield. So, a $1,000 face value bond might sell for $925.

Remember that time to maturity and the issuer’s credit quality also impact bond rates.