If the interest was paid on a monthly basis and retained in the account the interest earned would differ from the previous example, in effect you would then be earning interest on interest – this is referred to as compound interest.
Using the same figures as the example above, if the interest was paid monthly, the monthly interest earned would 5% divided by 12, or 0.417%.
Therefore the interest paid in the first month would be:
$1,000 x 0.417 / 100 = $4.17 per month
This brings your bank balance to $1,004.17 after the first month. For the second month, the interest will be calculated on your original $1,000 plus the previous month’s interest of $4.17. So you are earning interest on your interest.
We will show you an example of this on the next page.
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