Scribd
Upload
120 views4 pages

Compound Interest, Simple Interest

The document discusses the differences between simple interest and compound interest. Simple interest is calculated on the original principal amount each period, while compound interest is calculated on the accumulated balance which includes both the principal and previously earned interest. This results in compound interest earning more over time compared to simple interest. The document provides an example showing how $100 earning 10% interest annually would result in $110 after one year with simple interest, but $121 after two years with compound interest.

Uploaded by

Ben Plum
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
120 views4 pages

Compound Interest, Simple Interest

The document discusses the differences between simple interest and compound interest. Simple interest is calculated on the original principal amount each period, while compound interest is calculated on the accumulated balance which includes both the principal and previously earned interest. This results in compound interest earning more over time compared to simple interest. The document provides an example showing how $100 earning 10% interest annually would result in $110 after one year with simple interest, but $121 after two years with compound interest.

Uploaded by

Ben Plum
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
You are on page 1/ 4

COMPOUND INTEREST VS SIMPLE INTEREST

In accounting, time value of money indicates the relationship between time and money. Basically a
dollar received today is worth more than a dollar owed at some time in the future. A dollar is worth
more today because of the opportunity to invest the dollar and receive interest on the investment.

What is interest? Interest is payment for the use of money. It is the excess cash received or repaid
over and above the amount of money lent or borrowed. For example, if you lend a friend $100 at the
rate of 10 percent per year. After a year, your friend would owe you $110 ($100 borrowed plus $10 in
interest).

There are two methods of computing interest on money, simple interest and compound interest.

1. Simple interest is the return on the principal for one time period. The previous example is
an example of simple interest. Every year, interest is calculated based on the original amount
lent or borrowed.

2. Compound interest is the excess cash received over and above the amount of money lent
or borrowed for two or more time periods. Compound interest uses the accumulated balance
(original amount plus interest to date) at each year-end to compute interest in the next year.

Take the previous example, and change it from simple interest to compound interest. During the first
year, you would earn $10 in interest, $110 total. After the second year, you would earn $11 in interest,
for a total balance of $121. The extra dollar comes from the extra interest earned on the original
balance plus interest earned in year 1 ($110 X 10%).

The extra money earned by compounding interest makes it the obvious preferred method.
Compound interest is the typical method applied in business situations.

The Time Value of Money


Donna was puzzled about something, so she went to talk to Becky about it. She told her friend that
the problem is whether she would want a dollar today or a dollar one year from now. She doesn't see
what the difference is, since it's still one dollar, no matter when you get it.
Becky had to think about this for a while. When she sees Donna again, she tells her to take that
dollar now and put it in a savings account. The bank will pay interest, so one year from now she'll
have more than one dollar.
To sum up the time value of money, money that you have right now will be worth more over time.
So one dollar now will be worth more than a dollar in a year from now.

Future Value
Donna went home and did some research and she discovered a formula for future value, or how
much money put in the bank today will turn into at some point in the future with the interest. She
needs to know three things:

1. How much she has now


2. What the interest rate is
3. How many years she wants to put the money away for

Then she can use a formula to figure out how much she'll have at the end. The formula is:

FV = PV (1 + r)n
In this formula,

 PV is how much she has now, or the present value


 r equals the interest rate she will earn on the money
 n equals the number of periods she will put the money away, and
 FV equals how much she will have at the end, or future value.

Let's imagine that Donna puts $100 in the bank for five years at five percent interest, and plug that
into the equation.
FV = 100 (1 + 0.05)5
FV = 100 * 1.2762
FV = $127.62
Pretty nice, huh?

Present Value
Donna's parents think she's a pretty smart girl, especially after she shows her Dad these cool
formulas. Dad knows he will need money in a few years to pay for Donna's college. He's wondering
how much he can invest today in some CDs that would be worth $20,000 or so in 10 years when he'll
need it. Donna shows him a formula for present value, or how much you need to save today to
have a specific amount at some point in the future. Here's the formula:

PV = FV / (1 + r)n
In this formula,

 PV equals how much he needs to have today, or present value


 r equals the interest rate he'll earn
 n equals the number of periods before he needs the money, and
 FV equals how much he will need in the future, or future value.

So, if Dad needs the $20,000 in 10 years and can invest what he has for five percent, let's find out
how much he needs to invest today.
PV = $20,000 / (1.05)10
PV = $20,000 / 1.6289
PV = $12,278
Her dad is very happy to hear that.

Future Value of an Annuity


An annuity is a stream of equal payments. If Donna's parents give her an allowance of $20 every
month on the first, that's an annuity. It isn't just one allowance payment, but a stream of them,
since they happen every month, and it's always just the same amount.
Donna went and told Becky all about the formulas and Becky told her parents about how they work.
Becky's dad wants to save for Becky's college in a different way. He wants to put $1,500 in the bank
at the end of every year for 10 years. He wonders how much he'll have at the end.
Becky looks up a formula for that. It's called the future value of an annuity, which is how much a
stream of A dollars invested each year at r interest rate will be worth in n years. Here's what it looks
like:

FV A = A * {(1 + r)n -1} / r


In this formula

 FV A equals how much he will have at the end, or the future value of annuity
 A equals $1,500, his yearly payment
 r equals the interest rate he gets, and
 n equals the number of periods he makes those deposits.

So Becky puts the numbers in the formula. She comes up with this:
FV A = $1,500 * {(1 + r)n -1} / r
FV A = $1,500 * {(1.6289-1) / 0.05}
FV A = $1,500 * (0.6289 / 0.05
FV A = $18,867
Becky's dad was happy to hear that, since that's pretty close to what he'll need.

Present Value of an Annuity


Becky and her parents go to see Grandpa this weekend. He's getting ready to retire soon and he
would like to know how much he needs today to be able to draw out $50,000 a year for the next 20
years. Becky furrows her brow and then looks at the formulas again. She finds one for Grandpa. It
looks a bit tricky, but they'll figure it out.
It's called the present value of an annuity, which tells you how much you'll need today to receive
a stream of payments A each year for n years if the money is invested at r interest rate. Here it is:

In this formula

 PV A equals how much he needs today, or the present value of an annuity


 A equals $50,000, the yearly payment he wants
 r equals the interest rate he gets on his money, and
 n equals the number of periods.

The calculation is:


PV A = $50,000 * ({1 - (1 + 0.05)-20} / 0.05)
PV A = $50,000 * (0.62311 / 0.05)
Becky gets out her calculator to solve this since it has a big exponent. The answer is $623,110.
Grandpa isn't happy to see that, but he wants the calculator and the formula so he can play around
with some other numbers. He's thankful for the formulas.

You might also like