In investment terms, accrued interest is interest from a fixed-income investment, such as a bond has already earned, but has not been paid to the investment holder, usually because the payment is not yet due. Compound interest refers to when an investment earns interest on both the principal amount invested as well as the accumulated interest the investment has earned.
Bonds earn interest that is payable to bond holder's, typically every six months. The first accrued interest payment a bondholder receives is on the interest the bond earns from the time of purchase until the bond's next scheduled interest payment date. The bond accrues interest from one payment date to the next. If an investor decides to sell the bond, the buyer must pay the price of the bond plus the accrued interest the bond has earned since its last interest payment date.
On fixed-income investments, accrual periods are the lengths of time in which interest accrues. A typical accrual period for fixed-income securities, such as corporate and municipal bonds is 30 days with interest payment made twice per year. Accrual periods for a federal government bond are based on each calendar month. So if there are 31 days in a month, the interest accrual period is 31 days for that month, and if there are only 30 days in a month, the accrual period is 30 days for that month. Federal government bonds also typically make interest payments to its bondholders twice a year.
When you earn compound interest, you are earning interest on the principal amount you invested, plus any accumulated interest payment your principal investment has earned. For example, assume you make a $1,000 investment with an average 10 percent annual growth. The following year, your investment has earned $100 in interest so it is now worth $1,100. In the second year, you earn interest on the $1,100 value of her investment. You continue to earn interest on the initial $1,000 and on the $100 in interest earned in the first year.
Knowing how accrued and compound interest work can help you understand how your initial investment grows. One of the key components of how both accrued and compound interest make your money work for you is time. Generally, the longer you hold your investment, the more time you give it to earn interest, increasing its overall value.
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