Explaining simple and compound interest
In the run up to exams simple and compound interest is something on the list that a couple have asked about, so I thought I’d do a quick recap now.
There are 2 forms:
Clara invests £300 for 4 years in an account where she will earn 5% simple interest. How much will be in her account at the end of the 4 years?
£300 = 100% of the value
(divide by 100 to find 1%)
£3 = 1%
(multiply £3 by 5 to work out what 5% is)
£15 = 5%
With simple interest, each year they will give her another £15. If she keeps the money in the account for 4 years, they will give her 4x £15 (£60).
£300+£60 = £360
This time the amount of interest is calculated as a percentage of the money that is in the account.
So, if J invests £300 for 4 years in an account where he will earn 5% compound interest. How much will be in his account at the end of the 4 years?
This style just has one basic formula to learn:
£300 x 1. 05^4
We start with the £300 this is the initial investment.
We then multiply by 1: because it is an investment, he will get the initial investment back as well as the additional interest.
The 1 signifies the whole initial investment.
The .05 is the percentage rate.
It is .05 because we are multiplying by just 5% rather than 50%. (If it was 2.5% we would multiply by 1.025)
Finally, the power of 4 represents the 4 years that he will be investing the money for.
If we type this into the calculator we should get the answer: £364.65
So, in this instance J receives a slightly better return on investment than Clara.
That really was a simplified version of interest, but I hope it made sense.
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