Joined: 20 Jun 2009
Schools: Yale SOM Class of 2013
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Re: Simple and Compound Interest [#permalink]
18 Feb 2010, 08:09
Is there a specific question that you'd like help with? It may be easier to explain these concepts with a concrete example.
The key feature of compound interest is that interest is added to the principal at regular intervals, with the result that one earns "interest on interest". This is best illustrated using a simple example.
If you deposit $100 into a savings account with a simple annual interest rate of 10%, after one year you will have $100*(1+.1) = $110, after two years you will have $100*(2+.1) = $120, and so on.
If you deposit the same $100 into a savings account with a compound annual interest rate of 10%, a different outcome results:
- After one year, you'll have $100*(1+.1) = $110
- After two years, you'll have $110*(1+.1) = $121
- After three years, you'll have $121*(1+.1) = $133.1, and so on.
Note that you should pay very close attention to the period according to which the interest compounds. For example, if in the example above we knew that the interest compounded semi-annually rather than annually, we'd have to divide the interest rate by the number of periods (in this case two), and compound as usual:
- After the first six months, you'll have $100*(1+.05) = $105
- After the second six months, you'll have $105*(1+.05) = $110.25
Hope this helps.