If you loan your buddy a dollar for a soda pop and he pays you back the next day, you probably don’t worry about interest.
On the other hand, banks and credit unions loan much larger amounts of money for much longer periods of time. They also keep people’s money for them in savings accounts.
Both situations call for interest to be added to the amount of the loan or savings account.
The interest itself can reach fairly large values, so once it is added to the amount of the loan or savings account, it also earns interest the next time interest is calculated.
This effect of earning interest on previously earned interest is called compounding. Compound interest gets larger every interest period because the principal is larger each time.
This simulation will allow you to experiment with compound interest without needing any actual money to learn of its effects.
There are five parameters; the present value P, which is the amount saved or borrowed; the future value F, which includes the original amount plus the compounded interest, the annual interest rate r,
which is converted from a percentage to a decimal; t, the number of years the present value is to be compounded, and n, the number of times per year the interest is compounded.
Enter any three of the first four parameters, using the slider controls or by entering values into the entry fields. The remaining parameter will be calculated by the simulation …
… once a value for n is selected and the button is clicked.
A graph will be displayed, with the time and future value entered or computed highlighted.
One of the things you will want to investigate is the effect of more compounding periods.
Computing the interest more often would seem to produce more interest, but the fraction in the formula means the interest rate, and thus the interest, is smaller.
How do these opposing effects work against each other with compound interest?
And what happens when the interest is compounded continuously? This means the interest is computed every instant of time, but the interval during which the interval grows is infinitely small.
Can interest grow at all under these conditions?
You can use the simulation to compare how changing a single parameter alters the others and the graph.
Compound interest is the basis for other financial tools, such as mortgages and annuities, that you may need to use in the future, so it is a good idea to be familiar with compounding. Good luck and happy compounding!