Compound interest

Definition

Compound interest is the interest calculated on the initial principal, which also includes all of the accumulated interest from previous periods on a deposit or loan. This means that interest is earned on both the original amount and any previously earned interest, making it a powerful tool for growth in finance. The more frequently interest is compounded, the greater the total amount of interest accumulated over time, making it an essential concept in understanding exponential growth and the behavior of certain sequences and series.

5 Must Know Facts For Your Next Test

1. Compound interest can be calculated using the formula: $$A = P(1 + \frac{r}{n})^{nt}$$ where A is the amount of money accumulated after n years, including interest, P is the principal amount, r is the annual interest rate (decimal), n is the number of times that interest is compounded per year, and t is the number of years the money is invested or borrowed.
2. The frequency of compounding can greatly affect the amount of compound interest earned; common compounding intervals include annually, semi-annually, quarterly, monthly, and daily.
3. The 'Rule of 72' is a simple way to estimate how long it will take for an investment to double in value at a fixed annual rate of return. You divide 72 by your annual interest rate to get the approximate number of years.
4. In contrast to simple interest, which only applies to the principal amount, compound interest generates additional earnings on top of previously accrued interest, resulting in higher returns over time.
5. Compound interest is commonly used in savings accounts, investments, and loans, making it critical for financial planning and understanding long-term growth.

Review Questions

• How does compound interest relate to exponential functions and their graphs?
  • Compound interest illustrates exponential growth as the total amount increases not just based on the original principal but also on accumulated interest over time. When graphed, compound interest will show a curve that rises steeply as time progresses, demonstrating how quickly savings or investments can grow when reinvested. This relationship showcases how exponential functions can model financial scenarios where growth accelerates due to cumulative gains.
• Discuss how you would solve an exponential equation related to compound interest to find the time it takes for an investment to reach a certain amount.
  • To solve an exponential equation related to compound interest for time, you would use the formula $$A = P(1 + \frac{r}{n})^{nt}$$ and isolate t. This involves taking logarithms of both sides to simplify it into a linear form. By rearranging and applying properties of logarithms, you can derive t as $$t = \frac{\log(A/P)}{n \cdot \log(1 + \frac{r}{n})}$$. This method allows you to determine how long it will take for your investment to grow to a desired amount.
• Evaluate how different compounding periods impact overall returns on investments with compound interest over time.
  • Different compounding periods significantly affect overall returns because more frequent compounding leads to more opportunities for interest to accumulate. For instance, if you compare annual versus daily compounding at the same rate and principal, daily compounding results in a greater final amount due to the effect of earning 'interest on interest' more frequently. Evaluating these differences highlights how strategic choices in investment terms can maximize growth potential through effective use of compound interest.

Related terms

principal: The principal is the initial sum of money deposited or borrowed before any interest is applied.

exponential growth: Exponential growth occurs when a quantity increases by a consistent percentage over a period of time, leading to rapid increases as time goes on.

annuity: An annuity is a series of equal payments made at regular intervals, which can be used to calculate the future value of investments with compound interest.