ShmoopTube

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We speak student!

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Personal Finance 101

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Benjamin's Reproductive System

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a la Shmoop

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So now let's talk about Benjamin's reproductive system.

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You talked a little bit about interest.

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You've thrown out a couple terms.

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You talked about simple interest and compound interest.

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Can you define those terms for us?

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You bet. So simple interest is just the interest you get

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from typically a debt investment.

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Now there are two types of investments in this way.

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There's debt and there's equity.

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Debt is where you rent money, basically.

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Either you're taking out debt

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and you're renting money, like a mortgage that your parents probably have.

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And when you buy bonds,

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you're loaning someone money

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and you get interest back.

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Typically bond interest is paid twice a year.

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And the simple interest -- So let's say you loan someone $10,000

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at a five percent interest rate.

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You're gonna get five percent of $10,000 a year,

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or 2 and a half percent

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twice a year.

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That two and a half percent that you'll clip,

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that $250 that you'll get as interest twice a year,

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and then eventually you'll get the principal back,

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is the simple interest on the $10,000 loan that you've made someone.

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Compounding is different.

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So, for example, there's a thing called a "zero-coupon bond,"

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where lots of money will become available far down the line,

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but the guy who needs the money

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has no cash flow to pay interest today.

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So a zero-coupon bond pays

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zero interest, but the value accretes

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year after year after year.

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So you might loan someone $5,000 on a zero interest loan,

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and seven years later,

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you get $10,000 back,

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meaning you compounded at about ten percent a year with everything.

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So all of a sudden, you get ten grand from your five grand initial thing.

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That'd be an example of compounding the interest

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into then a one-time payment where you get all your money back.

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The more common use of compounded investments

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is in the stock market,

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where you typically don't take your money out each year.

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So you just leave your money in the stock market

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or the index funds or whatever vehicle you're using

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to invest in the stock market,

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and it compounds along year after year

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and you just get wealthy doing a whole lot of nothing.

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[ cash register sound ]

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So it sounds like compound interest is

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gonna make you more money if you have the time

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- to wait for it. - Exactly.

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They call that a liquidity premium

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or an illiquidity premium,

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meaning if you don't need the money now,

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you really get paid for it later.

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And it's sort of one of the things people say,

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"Well, this is how the rich get richer."

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The rich often don't need the cash today,

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so they can afford to just leave their money in the market

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and it makes life a whole lot easier when you're money's working for you,

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as opposed to you have to work for every dollar.

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[ typing ]

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[ whoop ]

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Can you define compound interest and simple interest?

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Does compound interest make you more money?

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[ impact grunt ]

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