Interest on Interest Suppose you locate a two year investment that pays 14 percent per year. If you invest $325, how much will you have at the end of the two years? How much of this is simple interest? How much is compound interest?
At the end of the first year, you will have $325 × (1 +.14) = $370.50. If you reinvest this entire amount, and thereby compound the interest, you will have $370.50 × 1.14 =$422.37 at the end of the second year. The total interest you earn is thus $422.37 325 =$97.37.
Your $325 original principal earns $325 ×.14 =$45.50 in interest each year, for a two year total of $91 in simple interest. The remaining $97.37 91 =$6.37 results from compounding. You can check this by noting that the interest earned in the first year is $45.50. The interest on interest earned in the second year thus amounts to $45.50 ×.14 =$6.37, as we calculated.