Compound Interest

Definition

Compound interest is the interest earned on interest, where the interest earned on the principal amount is added to the principal, and the resulting sum earns interest in the next period. This process continues, leading to exponential growth of the investment over time.

5 Must Know Facts For Your Next Test

1. Compound interest leads to exponential growth, where the investment grows at an increasing rate over time.
2. The formula for compound interest is $A = P(1 + r/n)^{nt}$, where $A$ is the final amount, $P$ is the principal, $r$ is the annual interest rate, $n$ is the number of times interest is compounded per year, and $t$ is the time in years.
3. Compounding frequency affects the final amount, with more frequent compounding leading to higher returns.
4. Compound interest is the key driver behind the time value of money, as it allows investments to grow at an accelerating rate.
5. Calculating present and future values of lump sums and annuities requires understanding the principles of compound interest.

Review Questions

• Explain how compound interest differs from simple interest and how it affects the growth of an investment over time.
  • Compound interest is the interest earned on interest, where the interest earned on the principal amount is added to the principal, and the resulting sum earns interest in the next period. This process continues, leading to exponential growth of the investment over time. In contrast, simple interest is the interest earned only on the principal amount, without any interest being earned on the interest itself. Compound interest results in a much higher final amount compared to simple interest, as the investment grows at an increasing rate due to the compounding effect.
• Describe the relationship between compound interest and the time value of money, and how it is used to calculate present and future values of lump sums and annuities.
  • The time value of money is the concept that money available at the present time is worth more than the same amount of money in the future due to its potential earning capacity. Compound interest is the key driver behind the time value of money, as it allows investments to grow at an accelerating rate. The formula for compound interest, $A = P(1 + r/n)^{nt}$, is used to calculate the future value of a lump sum investment. Conversely, the present value of a future lump sum or annuity can be determined by discounting the future cash flows using the compound interest formula. Understanding the principles of compound interest is essential for accurately calculating the present and future values of financial instruments.
• Analyze how changes in the compounding frequency, interest rate, and time period can impact the final amount of a compound interest investment, and explain the implications for financial decision-making.
  • The compounding frequency, interest rate, and time period are all key variables that can significantly impact the final amount of a compound interest investment. Increasing the compounding frequency, such as from annual to monthly or daily, will lead to a higher final amount, as the interest is earned on a more frequent basis. Similarly, a higher interest rate will result in a larger final amount due to the exponential growth. The time period is also crucial, as longer investment horizons allow the compounding effect to have a more pronounced impact. These relationships have important implications for financial decision-making, as investors can optimize their returns by selecting investments with favorable compounding frequencies, interest rates, and time periods that align with their financial goals and risk preferences. Understanding the nuances of compound interest is essential for making informed decisions about savings, investments, and other financial planning strategies.

Related terms

Simple Interest: Simple interest is the interest earned only on the principal amount, without any interest being earned on the interest itself.

Time Value of Money: The time value of money is the concept that money available at the present time is worth more than the same amount of money in the future due to its potential earning capacity.

Present Value: The present value is the current worth of a future sum of money or stream of cash flows, given a specified rate of return or discount rate.