Whether an investment pays simple interest or compounds the interest earnings has a significant impact on the future value of that investment. With a simple interest investment, you earn the same amount of interest each period – monthly, semi-annually or annually.
Compounding interest accrues to the investment, resulting in investment value growth and an increasing investment stream over time. For investors, the income stream from an investment may be interest or dividends, depending on the type of investment.
Read More: How to Calculate Simple Interest & Compound Interest
Bonds – Simple Interest
Investment bonds – government, municipal or corporate – pay simple interest. The coupon rate of a bond details how much interest a bond pays.
For example, a $100,000 bond with a 6 percent coupon rate will pay an investor $3,000 every 6 months until the bond matures. At maturity the $100,000 face amount will be paid to the investor. As a simple interest investment, the $6,000 in interest will be earned each year and not increase.
Zero Coupon Bonds – Compound Interest
An exception to the bonds that pay simple interest are zero-coupon bonds. These bonds are purchased at a discount to the face value and the interest is earned as the bond increases in value towards the maturity value. You only receive your interest when the bond matures, explains Investor.gov.
So, you might buy a $100,000 bond for approximately $60,000, with the interest compounding at roughly 3 percent until it reaches $100,000 in value in 15 years.
Read More: How to Calculate Compound Interest Payments
Savings Bonds – Compound Interest
U.S. savings bonds, in the form of series EE and series I bonds, earn compound interest, which will compound for up to 30 years after a bond is purchased. Series EE bonds earn a fixed rate of interest for the life of a bond. Series I bonds earn interest adjusted every six months for the rate of inflation.
Both types of savings bonds earn and accrue interest monthly. The interest on these bonds compounds semi-annually.
Whether an investment pays simple interest or compounds the interest earnings has a significant impact on the future value of that investment.
Stocks and ETFs – Dividends
Stock and exchange traded fund (ETF) shares held in a brokerage account earn simple interest in the form of dividends. The dividend earnings from these investment types will be credited to the cash balance of an investor's brokerage account. To keep the dividend earnings working, an investor must use the money in her brokerage cash balance to buy additional shares of stocks or ETFs.
Mutual Funds – Compound Interest
A mutual fund account allows an investor to elect automatic reinvestment of a fund's dividends into more shares of the fund. This feature allows investments in the simple interest bonds or stocks to become compounding investments.
A mutual fund is required to pay out interest or dividends earned by the fund's portfolio to investors in the form of dividends. Most bond mutual funds pay monthly dividends and many stock mutual funds pay quarterly dividends, all of which can be reinvested to compound the growth of a fund account.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.