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Time Value of Money:
Compound Interest
Let’s assume you have $50
in your saving account. How much will that $50 be in
one year? If the interest rate is 4 percent compounded
annually, your $50 will be worth $52:
$50 (principal) x 4 percent
(interest rate) = $2 (interest)
+ $50 (principal) = $52 after one year.
To figure out how much your $50 will be worth in two years, simply multiply
$52 by 4 percent and add the result to $52 for a total of $54.08:
$52 x 4 percent = $2.08 + $52 = $54.08 |
Compound interest can turn small amounts of money into large
ones. It makes the amount of money you have increase in value.
Sounds interesting, yes? All it takes for money to increase
in value
is three ingredients: an amount of money (large or small),
interest, and time.
Let’s begin with an amount of money that we’ll
also refer to as principal. In our example in the yellow
box, we use a principal amount of $50.
Interest is money banks pay you to use your money, or, your
principal. An interest rate is the amount of money banks
pay you to use your money and is based on the amount of your
principal. An interest rate is expressed as a percent, such
as a 4 percent interest rate. This means that the bank will
pay you 4 percent of the amount in your bank account. If
you were to tell someone what your bank is paying you to
use your money, you would say, “I am earning a 4 percent
interest rate on my money.”
Compound interest is earning interest on interest.
When the bank pays you interest, it automatically adds to
the principal in your bank account, which we’ll say
is $50. Banks usually pay interest once a month on the amount
of money in your account. That monthly interest payment is
referred to as: interest compounded monthly.
So let’s say the bank pays you interest in January
and adds it to the $50 in your account. When the bank pays
you interest again in February, you will earn 4 percent on
your $50, plus the interest you got paid in January. The
interest you earned in January is also earning the interest
you will earn in February.
Another way of talking about compound interest is to say
that the money you save works for you. You don’t have
do a thing, other than watch the bank pay you interest on
your principal, and then interest on your interest.
Now, we come to our final ingredient: time. The longer you
leave your money in your account, and let the bank pay you
interest, the more money you earn. Over time, you earn money
on a bigger and bigger pile of money.
To make this more clear, take a look at the example in the
yellow box. For simplicity, we assume that interest is paid
once a year, meaning that interest is compounded annually.
Use this calculating worksheet and watch your money grow >>
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