Compound Interest
You’ve located an investment that pays 12 percent. That rate sounds good to you, so you invest $400. How much will you have in three years? How much will you have in seven years? At the end of seven years, how much interest will you have earned? How much of that interest results from compounding? Based on our discussion, we can calculate the future value factor for 12 percent and three years as:
(1 +r )t = 1.123 =1.4049
Your $400 thus grows to:
$400 ×1.4049 = $561.97
After seven years, you will have:
$400 ×1.127= $400 ×2.2107= $884.27
Thus, you will more than double your money over seven years. Because you invested $400, the interest in the $884.27 future value is $884.27 400 = $484.27. At 12 percent, your $400 investment earns $400 ×.12 =$48 in simple interest every year. Over seven years, the simple interest thus totals 7 ×$48 =$336. The other $484.27 336 =$148.27 is from compounding.