Are you clear on the concept of interest? Or is simple and compound interest an area where you could use a brush-up? Whether you’re learning it for the first time or looking for a refresher, check out the video below to increase your knowledge!
Transcript: Simple and Compound Interest
This is one of my favorite topics here. Let’s begin with simple interest. Well, simple interest is a mathematical fiction, created to teach the idea of interest to grade school children. Absolutely, no one in the real world uses simple interest!
It is unlikely to appear on the test. With simple interest, the interest payment, the dollar amount of the interest payment is exactly the same each time. So let’s think about this. Bob deposits a $1,000 in an account that yields 5% simple interest compounding annually.
Well, 5% of a $1,000 is $50, so what this really means is that every year, Bob is going to get another $50 worth of interest. So in the first year, a $1,000 plus $50 we get $1,050. Then in the second year we add $50 again, then we add $50 again, and each year what we’re doing is we’re adding that same amount $50. So the account is rising by $50 each year.
The exact same dollar amount is added each time. Simple interest pays interest only on the principal and not on the interest. Thus, the amount of interests accrued makes no difference to the interest payment which is the same in each period. And indeed as this graph shows, if we were to graph the amount in the account versus time, it would rise as a straight line.
All that’s happening each year is another $50 is being added. So that’s why it rises at a constant slope. Simple interest is not often tested directly. But, and this is very important, it can be used for estimation purposes, and we’ll talk about this more later in this video. The big idea of compound interest, is interest on interest.
In compound interest, we get the percent of interest paid on the total amount that has already accrued in the account, principal plus all previous interest payments. Thus, the more interest that has accrued, the larger the amount of the next interest payment. No two successive interest payments are ever the same, so the dollar amount is always different.
Example of Compound Interest
The entire amount experiences the same percentage increase in each period. So that’s what stays the same, it’s not the dollar amount that stays the same it’s the percent increase that stays the same. That’s what’s going on in compound interest. So for example, Bob deposits a thousand dollars in an account that yield 5% in interest compounding annually.
So that means that every year, the amount in the account is going to experience a 5% increase, so it’s gonna get multiplied by 1.05 which is the multiplier for a 5% increase. So we start at $1,000. So we construct the multiplier 1.05 and multiply by 1.05, we get 1,050 notice that after one year that we get the exactly the same amount.
Either were simple or compound interest. And that will always be the case, if we’re compounding annually, but after one year one compounding period simple interest in compounding interest get exactly the same amount. After that they diverge. So after two years we multiply 1,050 by the same multiplier, we get 1,102.50 then multiply it, multiplier again, and again.
So these numbers started get very hairy. So first of all, don’t worry about getting these numbers by hand. You need a calculator to get this number, that’s important thing number one. Fourth thing, number two the notice is that say after four years, simple interest would get up to $1,200. So here we have $1,215.50, we’ve done a little bit better than simple interest would do for us.
Grand Scale Investing
Now, you might say well $15, what’s the big deal about that? Well, think about it this way. Here, we’ve only talked about four years, four years is a relatively short time in terms of investing. And we’ve only talked about a principle of $1,000. $1000 is peanuts in terms of large-scale investing.
And so, you really have to think about this in terms of a more grand scale. With large amounts of money and/or long periods of time, the difference between successive interest payments becomes substantial. Also, the difference between the total amount gained with compound interest versus the total amount gained with simple interest becomes substantial.
Big Idea Number One
So Big Idea #1, compound interest always out performs simple interest, as long as there’s more than one year. That is to say, as long as they’ve more than one compounding period.
And this graph really summarizes it. The green line is the straight line of simple interest. The purple curve is the line of compound interest, notice that it curves away from simple interest. It accelerates away from simple interest. So in the short term, it does a little bit better than simple interest.
Simple and Compound Interest: The Effect of Time
But then the longer we go, the more it diverges and it does much much better than simple interest does. By the end of this graph, notice that the compound interest payment, the compound interest total is over $1,000 more. That is the size of the principle, it’s more than a size of the principle above the simple interest.
Also notice in Y years, the principal be multiplied by the percent increase multiplier y time. Let P be the principal and r be the multiplier. Then the total amount in the account after N years is P times the multiplier of the power of Y. We can even be a little more formal about this. The annual percentage interest rate is I, then the multiplier for that we change the interest to a decimal.
That is divided by a 100, and then add 1, that’s how we get a percentage increase. So that’s the multiplier for an I percent increase. And of course, we’re gonna be multiplying by that y times.
Now, here’s what I’m gonna say, I printed a formula here. Do not, do not, do not memorize this formula. That would be a big mistake, instead, what I want you to do is understand the logic of how this formula was put together and when you’re doing a problem, rebuild the formula using that logic.
Simple and Compound Interest: Formula
Do not blindly memorize the result. So here’s a formula and I’ll show what I mean. Sheila invests $4,000 in an account that yields 6% compounding annually for 8 years. What is the total amount after 8 years? So again, don’t worry about getting the dollar amount.
Just worry about getting the correct formula, the correct expression for the amount that would be in the account after 8 years. And I’ll urge you to pause the video and try this on your own.
So here’s what I’ll say, here’s how we’ll approach this. The multiplier for a 6% increase, that’s 1.06. It’s gonna get multiplied by that eight times.
So the total amount in the account is gonna be 4,000 times that multiplier, 1.06 to the 8th. So that is the mathematical expression for the total amount in the account after 8 years. Now, of course, no one’s gonna expect you to calculate this without a calculator. But keep in mind that the test may not be asking for actual dollar amounts.
The test may well list answer choices. That are in this form, a certain amount times some decimal to a sum power, and then you have to recognize this particular one as the right answer. So sometimes the test actually does that and just knowing how to construct the formula is enough to get the answer. Things get more interesting when we change the compounding period.
Compound Interest: Changing the Compounding Period
Banks always give an annual percentage interest, but they may compound quarterly, or monthly, or even daily. For any compounding period smaller than a year, we need n, where n is the number of times that a compounding period would occur in a year. So for example, quarterly, that means n equals 4, we’re compounding 4 times a year.
Monthly, n equals 12, we’re compounding 12 times a year. Daily is 365, we’re compounding 365 times a year. Technically, we’d be compounding 365 days during regular year and 366 during a leap year. Let’s not even worry about it, the test is not going to get into the region, we have to worry about leap years versus regular years.
That’s not something that the test is gonna do to you. Suppose the bank pays 5% annual interest compounding quarterly. The bank does not pay as 5% each quarter. That’s not what’s going on, that would be unrealistically generous. Instead, the bank pays us 5% divided by 4 which is 1.25%, that’s the percent each quarter.
In general, if there are n compounding periods in the year, we divide the annual percentage interest by n to get the percent for each individual compounding period. So we divide by 4 for quarterly compounding. We’d divide by 12 for monthly compounding. The correct multiplier now would be the multiplier for a percent increase of I/n.
Write it Out Algebraically
So writing this out very algebraically, 1 plus I over 100n, that’s our multiplier. In y years, there would be n compounding periods each year, or n times y, in y years. And so, it means that we’re multiplying by that multiplier ny times, so the total formula is this. And again, do not, do not, do not, do not memorize this formula.
That would be an exceptionally bad idea.
Instead, I want you to think through the logic of it and as it were, rebuilt this formula each time using the logic of the situation, that is true understanding.
Here’s another problem, if Susan invests 1$,000 in an account that yields 5% annual, compounding quarterly, then how much does she have after 6 years? Again, don’t worry about getting an exact dollar amount.
Building the Correct Formula
Just see if you can build the correct formula. You can pause the video here and work on this. So the first thing I’ll say is that 5% annual has to get divided by 4. So the quarterly percentage is 1.25%. The multiplier for that is 1.0125. So that’s our multiplier.
The amount in the account experiences that percent increase 4 times each year or 24 times in six years. So we’re multiplying by that multiplier 24 times. So the final amount will be the principal, $1,000, times that multiplier to the power of 24. And okay, so that’s the expression.
And again, the problem is simply looking for building the correct formula. That’s the correct formula.
Or You Can Approximate
I’ll also say that we could approximate this. Sometimes the test will want us to approximate. We can approximate using simple interest. So lets think about this 5%, that’s $50.
So that means in 6 years, they’d get $50 6 times $300, that means simple interest gives us $1,300. So we can estimate that the compounding interest over 6 years is gonna be something slightly more than $1,300. Probably not gonna be as large as $1,400, so that kind of gives us a ballpark range for how much interest we’re going to accrue here.
How does the size of the compounding period determine the interest earned over time? For this, we will need a large principle and a long amount of time. Let’s say that the annual interest rate is 5%, the principal is $1,000,000, and the time is 20 years. So we’re really pumping up both the amount that we’re dealing with as well as the time to look at these subtle differences.
So on that scale, simple interest would give us $2,000,000 up to 20 years. Compounding annually would give us 2.6, and then we see the other numbers for compounding quarterly, monthly, daily, and hourly. Notice that, as we up the compounding, the more and more compounding we do, the amount of total interest we get paid increases, as the compounding period decreases the overall amount of, if interest earned increases.
Simple and Compound Interest: Summary
So that big idea also, you always do better with more compounding. In summary, we talked about simple interest. Not very realistic, not likely to appear by itself, but an excellent approximation tool. We’ve talked about compounding annually, then we talk about compounding other periods quarterly and monthly.
One big idea is that compound interest always pays more than simple interest, that’s a really important idea. That’s important especially when you’re using the simple interest approximation. And also, it’s important to know that more compounding periods give us more money.