Personal Finance / Unit 4: Saving and Investing
4.2 Compound Interest
Notes
Compound interest is paid on the principal and on interest already earned ("interest on interest"). Savings grow faster than with simple interest.
- Formula for yearly compounding: $A = P(1 + r)^t$.
- Example: $1,000 at 10% compounded yearly. Year 1: $1,100. Year 2: $1,210. Year 3: $1,331.
- Simple interest on the same deal would give only $1,300 after 3 years.
- Starting early matters most: time lets compounding build.
- The same idea works against you on debt that compounds.
Practice
What makes compound interest different from simple interest?
Compound interest includes interest on interest.
$500 is invested at 10% interest compounded yearly. What is the value after 2 years?
Year 1: $550. Year 2: $550 \times 1.10 = 605$.
$2,000 grows at 5% for 2 years. How much more interest does yearly compounding earn than simple interest?
Simple: $200. Compound: $2000 \times 1.05^2 = 2205$, so $205 interest. The difference is $5.
Ready for more? Take the Unit 4 test.