Simple and Compound Interest

September 14, 2008

There aren't a lot of interest questions on the GRE Quantitative section, but when they arise, there are a couple of terms you need to know.

As far as most standardized tests are concerned, there are two types of interest: "simple" and "compound." Compound is more common in the real world--if you have a savings account, you probably earn compound interest. Simple is, well, more simple.

Simple Interest

Regardless of which type of interest is used on a particular question, it's always given as a percent. For instance, an investment might return 10% simple interest, or 5% compound interest. After that, they diverge.

When you're working with simple interest, the yearly return never changed. If $100 is invested in a savings account that earns 10% simple interest, the return is $10 per year. That's 10% of $100 each and every year, even though, after the first year, there's more than $100 in the account.

Compound Interest

With compound interest, the base amount changes each year. If $100 is invested in a savings account that earns 10% compound annual interest, the account earns $10 the first year, but after that, the return is greater.

At the end of the first year, the account contains $110, so 10% interest the second year is 10% of $110, or $11. The next year, it's 10% of $121, or $12.10. Each year, the interest amount is greater than the previous year.

Applications

As I mentioned at the outset, interest questions aren't common on the GRE, so you shouldn't expect anything much more complicated than this. It's useful to recognize that, given the same investment amount and interest rate, compound interest earns more than simple interest. Beyond that, interest questions are just another of the many flavors of GRE percent problems.

Jeff Sackmann is a test-prep tutor based in New York City and the author of Total GRE Math, among other GRE and GMAT resources.

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