Do you know the difference between compound interest and simple interest? For instance, if someone comes along and say, “I can double your money in 6 years”, does that sound like a good offer? 100% return, my friend!
If you knew the difference between simple interest and compound interest, then you might not be all that excited. If the 100% is based on simple rate of return, then your compounded rate of return is only about 12% per year!! A huge difference between 100% and 12% and not all that spectacular, isn’t it?
The example below will illustrate this. Say you invest 10,000 and double the money in 6 years means $ 20,000.
Simple interest = ( 20,000 – 10,000 ) / 10,000 x 100
= 100%
Compound interest calculated step by step is as follows:
Year 1. 10,000 x 12% = $11,200
Year 2. 11,200 x 12% = $12,544
Year 3. 12,544 x 12% = $14,049
Year 4. 14,049 x 12% = $15,735
Year 5. 15,725 x 12% = $17,623
Year 6. 17, 623 x 12% = $19,738 or approximately 20,000
For a quick way to estimate compounding interest, you can use the Rule of 72.
From the concept of compounding interest above, the concept called time value of money is developed. And all the calculation steps can be expressed in a simple equation as here.
