Understanding Interest-On-Interest

Jul 19, 2022 By Susan Kelly

Security of financial worth which pays investors IoI is that of the U.S. Savings bond, which a government entity can issue to collect cash from its public for its capital projects and other activities necessary to manage the economy. Savings bonds are bonds with no coupon and don't pay interest until they're redeemed or are mature. The interest is compounded semi-annually and will be paid monthly for 30 years.

A person who buys the bond at the close of the month will be able to receive the interest that accrued for the entire month as the Treasury does not count the full month. Any interest paid upon the time of redemption or maturity date is then electronically transferred to the bondholder's account at the bank.

How Interest on Interest Works

Interest on interest is earned according to the definition by paying interest on interest paid in the past received and the principal amount initially saved or invested. For instance, U.S. Savings bonds are financial security that pays investments with interest semi-annually and is paid monthly for 30 years. Savings accounts at banks also offer interest on interest, and payments are made on a monthly basis.

How to Calculate Interest on Interest

The compound interest formula determines accumulated interest on the principal amount invested. The principal amount, the annual interest rate, and the number of compound times are used to calculate the compound interest of the loan or deposit. The formula used to calculate compound interest would be to multiply 1 by an interest rate expressed in decimal format and then increase this amount by the number of compounding periods by multiplying this formula with the principal amount. The principal amount of the original calculation will be subtracted from the final amount.


For example, suppose you are trying to calculate the compound interest for one million dollars of deposit. It is compounded each year at 5 percent. The total number of compounding periods is five, equivalent to five one-year intervals.

What Is Interest?

Interest refers to the amount paid on loans, investments, or deposits. It is an amount from the potential cost of lending, depositing, or investing funds to someone who is not utilizing your money for a certain time. The longer the duration, the more perceived risk associated with giving your money away, and the greater the amount of interest required. Therefore, interest can be considered an aspect of the "cost of money" or the cost of the "time value of money."

Examples of Simple Interest vs. Interest-On-Interest

Look at a bond with 10,000 in par value with 10 years remaining until maturity. The interest rate of this bond will be 5% and increase annually. If the bond is a rate-paying Treasury Bond (T-Bond) or traditional corporate bond, investors will receive (5%/2) 10,000 = 2.5 x 10% each time they pay. In all, they'd receive $500 annually in interest earnings. Note that the interest only applies to the principal or par value amount.

In contrast, it is the case if the bond is such as one of the Series EE bond (a type of U.S. Savings bond), the interest that is calculated over some time will be added on top of the interests that was earned and accrued from previous periods. Because the savings bond will not earn interest until it is matured, the interest earned is added to the amount that is the primary bond's value, thus increasing the value of the bond.

In the example above that we have used, the initial interest paid on the bond of 10 years is $250. The second period of interest is calculated based on the increase in value that the bond has. In this scenario the amount of interest paid for the second compounding time is: 2.5 percent multiplied by ($10,000 and $250) = 2.5 10% x 10250 = $256.25. In the first year of holding this bond, would earn $250 + $256.25, which is $506.25. The third interest rate could be converted to 2.5 percent multiplied by ($10,250 and 256.25), which equals $262.66.

Special Considerations

When looking at possible investments and attempting to estimate the entire cash return of an investment, one must remember that interest-on-interest is an important factor that must be taken into account. When determining the amount of interest earned on interest, it is essential to keep in mind that the number of compounding periods considerably impacts the calculation. The general principle states that the amount of interest earned on interest is proportional to the number of compounding periods used.

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