Compound interest is one of the amazing wonders of the financial world. When money is invested in a instrument that pays interest, and that money is left invested so that the interest will also make interest, the power of compounding increases the yield much more than a simple interest investment. Many financial investing instruments, such as certificates of deposit, which are readily available at local banks, give a fixed yearly rate of return, and the interest is compounded. Knowing the amount of starting principal invested, the yearly interest rate, the rate of compounding and the length of time invested, we can find the value at maturity by using a calculator.
- Skill level:
- Moderately Easy
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Things you need
- calculator, preferably one that has a "raise to a power" function button
Divide the interest rate (expressed as a decimal) by the number of interest periods per year. For example, if the interest is compounded daily, the number of interest periods per year would be 365. If compounded monthly, this figure would be 12, and if compounded quarterly, use 4. The interest rate should be expressed as a decimal; 5% annual interest rate would be entered as .05. For our example, .05 divided by 365 = 0.0001369.
Add 1.0 to this figure. Our example figure would then be 1.0001369.
Raise this figure to the power of the number of conversion periods (interest periods) we want to elapse. If the interest is given quarterly and maturity is in one year, then the number of conversion periods would be 4 (should your calculator not have the "raise to a power" function, multiply the figure by itself the number times of conversion periods). If the interest is given monthly, then the conversion periods would be 12. In our example, the interest is compounded daily, or 365 times a year. If we want to find the future value of our CD in one year, then the number of conversion periods would be 365. If our CD matured in 2 years, then the conversion periods would be 365 times 2, or 730. For our example, we'd use 365. 1.0001369 raised to the power of 365 = 1.05123.
Multiply this result by the initial principal amount. In our case, that is £325. 1.05123 times £325 is about £341.6, give or take a penny for rounding off. At maturity, we would have £341.6, and our yield would be £16.60, which is the value at maturity less the starting principal.