Non-compounding v compounding interest

Every healthcare entrepreneur should understand the difference between non-compounding and compounding interest. Not all investment vehicles provide compound interest, and knowing how one's pre-tax investment grows (or doesn't) helps in forecasting the needs of your venture. Let's dive in and if you need a refresher on interest rates, see our tutorial here.

Non-compounding interest

Non-compounding interest is the amount of growth that your investment will experience in a particular period. The growth you experience is not re-invested into the investment vehicle, so you continue to earn the same amount of interest each period. Non-compounding interest-earning vehicles, such as corporate or government bonds, are common and offer benefits not found with compounding interest earning ones. But first, let's see how you earn using one of these vehicles.

Suppose you invest $1.00 at t = 0 into an investment vehicle that provides a 5% simple interest rate. At the end of the first period, you earn $0.05 (5% of $1.00). Because the vehicle is non-compounding, your $0.05 earned is not reinvested and as a result, you earn another $0.05 in period 2. Suppose you remain invested for 12 periods - your returns will be the following:

Note that the APY, or annual percentage yield, equals the SAIR. The APY is a metric that has meaning when the investment vehicle compounds interest payments. In this case, there is no compounding, so the APY = SAIR.

Compounding interest rate

Now let's look at an investment vehicle that provides compounding interest, like a certificate of deposit (CD). Again, you invest $1.00 into the vehicle for 12 periods at a simple interest rate of 5% - the same parameters as the previous example. During the first period, you earn $0.05. Because the investment compounds interest, the $0.05 you earn is immediately reinvested into the vehicle. Thus, at the end of period 1, you have a zero cash flow -- the only cash that you could have received was wholly reinvested back into the vehicle.

The difference between these two vehicles is the total profit. Vehicle 1 results in a $0.60 profit; vehicle 2 an $0.80 profit. The increase in profit in the compounding interest vehicle results in an APY of 80%. The APY tells you what you actually earn over the course of a year if the investment compounds your earnings. The fact that the APY and SAIR are unequal is the tip-off that the vehicle compounds interest.

Why do non-compounding interest vehicles exist?