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Compound interest 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 someone were to receive 5% compound interest on a beginning value of $100, the first year they would get the same thing as if they were receiving simple interest on the $100, or $5. The second year, though, their interest would be calculated on the beginning amount in year 2, which would be $105. So their interest would be:
| .05 × $105 – 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 this:
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
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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.
Simple Interest
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Compound Interest
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