Interest Income

You may have heard it say that you should, “Let your money work for you.” What does that mean? Take a look at Matthew 25:14-30, known as the Parable of the Talents. We looked at this parable from a spiritual standpoint in an earlier lesson. Now we will look at this from an investment standpoint. In this story, Jesus talks about investing, bankers, and interest! He tells about three servants who were each given some of their master's money. The first two servants used the money to make more money for their master. In other words, they invested it. The third servant, however, hid his money away and did nothing with it. This angered the master, and so the master took his money away and gave it to the first servant. The master goes on to say "For to everyone who has will more be given, and he will have an abundance. But from the one how has not, even what he has will be taken away" (Matthew 25:29).

The principle we glean from this parable is that Jesus expected an increase from our investments -- whether using our gifts and talents or as in this lesson with our money. When you invest your money, you earn interest on money that you are not using at the time. How much can you earn, and what are some of the typical rules governing the amounts you can earn? Let’s take a look.

Vocabulary

interest - money that is earned or paid that is calculated based on a set rate usually quoted as a percent 

interest rate - the percentage rate at which you will either be paid or charged that affects the interest

simple interest - the interest that is received based on a yearly rate and calculated once a year and then added to the original principal invested

compound interest - interest that is received based on both the rate on the principal amount, but also on the added interest; interest can be compounded annually, semiannually, monthly and even daily; Example: when it is done monthly, it is assessed as 1/12 the annual rate, so if you earn 6% a year, then monthly you would earn 1/2 x 6 = 6/12 or 0.5%, but since it is added monthly, your rate of return would be more.

principal - that initial amount of money that you are either investing or borrowing

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So how do we calculate simple interest? The formula that we use you may have seen in Math class:  I=PRT. In this formula, I = Interest, P = Principal, R = Rate (expressed as a decimal), and T = Time (in years).

For example, imagine you have $100 and you plan to put it in a bank for 6 years at a 6% interest rate.  Here is the calculation:  $100 x 0.06 x 6 = $36

The amount of interest you would earn on the initial $100 is $36.

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My wealth has come from a combination of living in America, some lucky genes, and compound interest.

- Warren Buffett

So, how do we calculate compound interest? The formula we use for this is similar to simple interest: (Principal + Earned Interest) x Rate (expressed as a decimal) x Time (in years). 

For example, imagine you have the same $100 as above and plan to put it in the same bank for 6 years at a 6% interest rate. But now, the interest is compounded. That means each year the interest is added, and then the principal is recalculated and interest is earned on the new amount. Take a look at the calculations:

The total interest earned after six years would be $41.83. Let's keep reading for an even better understanding of interest income.

Compound Interest

Just like compound words are made of more than one word, a compound in chemistry is made of two or more substances, and other uses of the word compound to mean two or more, compound interest is much more than simple interest.

Simple interest is based on calculating interest one time for a certain amount over a specified time period with a set interest rate.

Interest calculation is an important concept to understand. It is the basis for financial institutions earning income for administrators and paying dividends for participants and stockholders. Interest and returns on investments drive Wall Street and the stock market. Interest also helps the individual plan for retirement and reach financial goals. Understanding interest helps you make better financial decisions.

The compound interest formula accounts for the fact that as you invest and earn interest, your balance grows from both the amount of your initial principal and the interest added to that principle periodically. Thus you get paid for interest on the interest. That is what compounding interest is all about. 

There are different ways to make money. One way is to earn interest on the money you have saved.