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Compounding Interest and the Banker
There are many factors influencing the cost of money
for both individuals and corporations. Suppose you deposit money in an interest
bearing account and at the same time borrow a bit of money from the same bank.
which account would the bank apply quarterly compounding factors versus
your choices and your reasoning. You may want to check your personal
accounts in regard to this type of transaction.
If I were to deposit money in an interest bearing account,
such as my current savings account, this account would earn compound interest.
According to handsonbanking.org, “If account pays compound interest, that
means the financial institution will pay you interest not only on your
original deposit but also on the interest your deposit has earned over
time. With compound interest, your money grows more — and a lot faster!”
(2015). For example, every two weeks, I put $250 directly into my savings
account. This means that monthly, I increase my savings account by $500. Over a
month’s time, my bank applies earned interest into my savings account. Though
it is literally pennies at a time, the bank looks at the current amount that I
have in my savings, and applies compound interest due to the amount at that time.
As for the account in which I am borrowing money from the same bank, this
account would accrue simple interest. According to investopedia.com,
“Simple interest is called simple because it ignores the effects of
compounding. The interest charge is always based on the original principal, so
interest on interest is not included” (2015). This means that if I were to
borrow $5,000 at a 2% interest rate, the 2% could be a simple interest, and I
accrue interest on the $5,000 that I originally borrowed.
The bank would apply quarterly compounding interest in
a savings account because as you save money the interest will earn interest
(Foreman, 2012). For example if an account had $200 dollars and at the
end of the quarter it had $5 earned in interest the following quarter it would
earn interest on $205 as opposed to the original $200. Over time this would
generate a much larger amount on interest earned then simple interest would.
If someone borrowed money for a car loan for example
through a bank they would probably use simple interest this is because just as
the amount earned in a savings plan would snowball the same would be true of
the amount owed on a car loan if the interest was compounding. By using a
simple interest rate the borrower is basically paying a flat percentage for the
amount borrowed. Even though the loans are amortized so that the interest is
frontloaded in the payment schedule the interest rate remains the same. It
seems that if banks could get away with it and in order to maximize profits
they would probably reverse the two scenarios so that compound interest is paid
on a car loan and only simple interest is paid in a savings account.
Foreman, G. (2012). 10 Things you need to know about
compound interest. Retrieved 04/21/2016 from http://money.usnews.com/money/blogs/my-money/2012/09/20/10-things-you-need-to-know-about-compound-interest