What is Compound Interest?
There are two kinds of interest – simple interest and compound interest. You probably know how simple interest works.
There are two kinds of interest – simple interest and compound interest. You probably know how simple interest works. For example: If I have $10,000 and I earn 6% interest, how much money do I earn after one year?
Answer: $600
If I earned 6% every year for 12 years how much money would I have earned in interest?
Answer: $600 per year x 12 years = $7200. So adding that to my initial investment, I’d have a total of $17,200
Compounding Interest
If I have $10,000 and I earn 6% compounding interest, how much money do I earn in interest?
Answer: $600
If I earned 6% every year for 12 years how much money would I have earned in interest?
Answer: $600 per year x 12 years = $7200. So adding that to my initial investment, I’d have a total of $17,200
Compounding Interest
If I have $10,000 and I earn 6% compounding interest, how much money do I earn in interest?
Answer: Well, if I apply the “Rule of 72” (which we discussed in our last post) 72 divided by 6 (the rate of interest) = 12. That means my total money will double in 12 years to $20,000.
So why is the total amount of money higher with compounding interest than with simple interest ($20,000 compared with $17,200) if they both receive 6% interest?
Answer: With simple interest I earn the same amount of interest each year on the original $10,000. So every year I only receive $600. With compounding interest, I add $600 (interest) to my original $10,000. Then the next year I earn 6% on $10,600 which is $636. When added together I have $11,236. The following year I earn 6% on that amount
End of year 1 - $600 + $10,000 = $10,600
End of year 2 – 6% x $10,600 = $636. $636 + $10,600 = $11,236
End of year 3 – 6% x $11,236 - $674.16. $647.16 + $11,236 = $11,883.16
End of year 4 – 6% x $11,883.16 - $712.99. $712.99 + $11,883.16 = $12,596.15
End of year 5 – 6% x $12.596.15 - $755.77. $744.77 + $12.596.15 = $13,391.92
Do you see how this is calculated? Dan you continue to do the math?
So why is the total amount of money higher with compounding interest than with simple interest ($20,000 compared with $17,200) if they both receive 6% interest?
Answer: With simple interest I earn the same amount of interest each year on the original $10,000. So every year I only receive $600. With compounding interest, I add $600 (interest) to my original $10,000. Then the next year I earn 6% on $10,600 which is $636. When added together I have $11,236. The following year I earn 6% on that amount
End of year 1 - $600 + $10,000 = $10,600
End of year 2 – 6% x $10,600 = $636. $636 + $10,600 = $11,236
End of year 3 – 6% x $11,236 - $674.16. $647.16 + $11,236 = $11,883.16
End of year 4 – 6% x $11,883.16 - $712.99. $712.99 + $11,883.16 = $12,596.15
End of year 5 – 6% x $12.596.15 - $755.77. $744.77 + $12.596.15 = $13,391.92
Do you see how this is calculated? Dan you continue to do the math?
