Finance: Interest on Interest

In order to succeed at something, whether it is starting a business or getting good grades in school, it is always important to ask for help. However, when help is needed in a financial situation, it is always important to pay someone back especially if there have been transactions with money made. This simple concept is what is called interest on interest. To expand further, interest on interest can be defined as interest that is earned when interest payments are reinvested primarily in bonds and coupon-payment methods.

Interest on Interest can also be seen in financial security through the payment of investors for a US Savings Bond. These bonds involve the zero-coupon bond rule, to ensure that the bonds are not redeemed until the interest is paid. These interest compounds then circulate around for around a year until the treasury can count them. Once the investor purchases the accrued interest from the previous months (mentioned above), interest paid at redemption date can be issued electronically.

After the bank account is established, interest can become simple interest or compound interest. Simple interest is only charged on the beginning amount, while compound interest is charged the exact opposite way. An example of simple interest can be seen in a Treasury Bond because it is a type of debt security. Based on this, if the interest rate on the bond is 5% and compounds semi-annually. If this bond was a Treasury bond or conventional corporate bond, investors will receive a lot of money each payment period. So, they would be able to receive anywhere from $500+ per year in interest income. Also, Interest only applies to the par value or principal amount. Thus, on the other hand, if the bond was, a Series EE bond (a type of U.S. Savings bond), the interest calculated for a period is added to the interest earned and accumulated from prior periods. Since the savings bond does not pay interest until it matures, any interest earned is added back to the principal amount of the bond, increasing the value of the bond.

To demonstrate this more clearly, here is a diagram of an example problem, that has been gathered from Investopedia.com:

Interest-on-interest can be calculated using this formula: P [(1 + i)n – 1]

Where P = principal value

i = nominal annual interest rate

n = number of compounding periods

An investor who holds this bond until it matures after 10 years (or 20 payment periods) will earn:

Interest-on-interest = $10,000 x (1.02520 – 1)

= $10,000 x (1.6386 – 1)

= $10,000 x 0.638616

= $6,386.16 {Answer}

Works Cited

Chen, James. “Interest-On-Interest.” Investopedia, Investopedia, 13 Dec. 2018, www.investopedia.com/terms/i/interestoninterest.asp.

By: Seetha Murugappan