Compound Interest

Definition

Compound interest is the interest earned on interest, where the interest accumulated from previous periods is added to the principal amount, and interest is then calculated on the new, higher balance. This concept is central to understanding how households can supply financial capital and accumulate personal wealth over time.

5 Must Know Facts For Your Next Test

1. Compound interest allows money to grow exponentially over time, as the interest earned in each period is added to the principal and earns interest in the next period.
2. The more frequently interest is compounded (daily, monthly, quarterly, etc.), the higher the effective annual yield will be for the same stated interest rate.
3. Compound interest is a key driver of wealth accumulation, as it allows savings and investments to grow at an accelerating rate over long time horizons.
4. The power of compound interest is often illustrated through the 'rule of 72,' which states that the time required to double an investment is approximately 72 divided by the annual interest rate.
5. Households can utilize compound interest to their advantage by saving and investing consistently, starting at an early age, to maximize the long-term growth of their financial capital.

Review Questions

• Explain how compound interest can help households supply financial capital over time.
  • Compound interest is a crucial concept for households looking to supply financial capital. By consistently saving and investing, households can leverage the power of compound interest to grow their savings and investments at an exponential rate. As the interest earned on the principal is reinvested, it begins to generate its own interest, leading to a snowball effect that can significantly increase the household's financial capital over long time horizons. This allows households to more effectively supply financial capital to the economy, whether through direct investments or through financial intermediaries like banks and investment funds.
• Describe how the concept of compound interest relates to the accumulation of personal wealth.
  • Compound interest is a fundamental driver of personal wealth accumulation. By consistently saving and investing, households can take advantage of the exponential growth that compound interest provides. The more frequently interest is compounded (e.g., daily, monthly, quarterly), the higher the effective annual yield will be, even at the same stated interest rate. This allows households to grow their savings and investments at an accelerating rate over time, enabling them to accumulate significant personal wealth. The 'rule of 72' illustrates the power of compound interest, as it shows that the time required to double an investment is approximately 72 divided by the annual interest rate. Households that start saving and investing early, and leverage the benefits of compound interest, are better positioned to achieve their long-term financial goals and accumulate personal wealth.
• Analyze how the time value of money concept is related to the understanding of compound interest and its impact on household financial decision-making.
  • The time value of money is closely tied to the concept of compound interest and its importance in household financial decision-making. The time value of money principle states that a dollar today is worth more than a dollar in the future due to the potential earning capacity of the present dollar through compound interest. Households that understand this concept are better equipped to make informed financial decisions, such as when to save, invest, or borrow. By recognizing the power of compound interest, households can prioritize saving and investing early, as the earlier they start, the more time their money has to grow exponentially. This allows households to maximize the long-term growth of their financial capital and accumulate personal wealth more effectively. Conversely, households that fail to grasp the time value of money and the impact of compound interest may make suboptimal financial choices, potentially limiting their ability to supply financial capital and build personal wealth over time.

Related terms

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

Annual Percentage Yield (APY): The annual percentage yield is the effective annual rate of return, taking into account the compounding of interest over time.

Time Value of Money: The time value of money is the concept that a dollar today is worth more than a dollar in the future due to the potential earning capacity of the present dollar through compound interest.