Time Value of Money
Compound interestCompound Interest:Interest paid on beginning principal and any additional accumulated principal. is another matter. It's good to receive compound interest, but not so good to pay compound interest. With compound interest, interest is calculated not only on the beginning interest, but on any interest accumulated in the meantime.
For instance, if one were to receive 5% compound interest on a beginning value of $100, the first year interest would be the same as simple interest on the $100, or $5. The second year, though, interest would be calculated on the beginning amount of year 2, which would be $105. So the interest would be:
$105 × .05– or –$5.25 in Interest
This provides a balance at the end of year two of $110.25. If this were to continue for 5 years, the growth in the investment would look like:
Year 1: 5% of $100.00 = $5.00 + $100.00 = $105.00
Year 2: 5% of $105.00 = $5.25 + $105.00 = $110.25
Year 3: 5% of $110.25 = $5.51 + $110.25 = $115.76
Year 4: 5% of $115.76 = $5.79 + $115.76 = $121.55
Year 5: 5% of $121.55 = $6.08 + $121.55 = $127.63
Note that in comparing growth graphs of simple and compound interest, investments with simple interest grow in a linear fashion and compound interest results in geometric growth. So with compound interest, the further in time an investment is held the more dramatic the growth becomes.