How Much of Your Investment Income is Actual Earned Interest?
The discount rate is a simple mathematical equation that, when followed correctly, enables someone to determine what percentage of their future value is interest and what percentage is principal. This is done by dividing the current interest rate by the number one plus the current interest rate.
The equation appears as follows: Discount rate = interest rate/ (1 + interest rate)
For example, if $1000 were put into an investment that pays 30% interest after five years, then the total amount withdrawn from that investment at the end of those five years would be $1300. Therefore, following the equation above, the discount rate would be 0.3/ (1 + 0.3) = 0.3/ 1.03 = 23%. Thus, it can be determined that of the $1300 withdrawn after five years, 23% of that is interest earned and the remaining 77% is principal.
Another way to think of the discount rate refers to the discount of future cash flow. For example, if you were to purchase a $100 investment that would pay out $150 after a year, the formula would be calculated as follows:
(150-100) / 150 = 1/3 or 33%
The interest gained from the purchase can also be calculated by using the initial investment as the base of the equation instead of the total payout:
(150-100) / 100 = 50%