Eunchae invested $2,000 six years ago at 4.5 percent interest. She spends all of her interest earnings immediately so she only receives interest on her initial $2,000 investment. Which type of interest is she earning?

Question

BlackTom AI · Accepted Answer

Let's break down the scenario and evaluate what each term means in relation to Eunchae's situation.
Option 1: 'Interest on interest' — This describes compound interest, where interest is earned on both the initial principal and on accumulated interest from prior periods. Since Eunchae spends all of her interest earnings immediately and does not let interest accumulate, this option does not apply.
Option 2: 'Complex interest' — The term 'complex interest' is not a standard designation in finance for how interest accrues. It may be used informally, but it does not describe a recognized method where interest compounds on itself. Because Eunchae is not allowing interest to compound, this label is inaccurate.
Option 3: 'Simple interest' — Simple interest accrues only on the original principal, not on any interest earned. The fact that Eunchae spends all of her interest earnings and does not reinvest them means she is earning interest solely on the initial $2,000 each period, which matches the definition of simple interest.
Option 4: 'Compound interest' — Compound interest involves earning interest on both the principal and the accumulated interest from previous periods. Since Eunchae withdraws or spends all interest each period, there is no accumulation of interest on interest, so compound interest does not describe her situation.
Option 5: 'Free interest' — This term does not correspond to a recognized category of interest calculation in financial theory. It lacks a concrete definition in relation to how interest is calculated, making it an incorrect label for the described mechanism.
In summary, the key distinction hinges on whether interest is earned only on the initial principal or on the principal plus previously earned interest. Because Eunchae's policy is to spend all interest and not let it compound, the scenario aligns with simple interest rather than any form of compounding.

BUSFIN 3220 AU2025 (2910) Exam 1 - Requires Respondus LockDown Browser

Eunchae invested $2,000 six years ago at 4.5 percent interest. She spends all of her interest earnings immediately so she only receives interest on her initial $2,000 investment. Which type of interest is she earning?

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