Compound interest is interest calculated on both the initial principal and all of the previously accumulated interest. Learning about the basics of compounding and interest rates can help youngsters to start investing in small amounts early and take advantage of time in their lives.
Compounding was considered as the eighth wonder of the world by Albert Einstein and Warren Buffet loves compound interest. The formula essentially goes like the rate of interest for the specific period of time and the number of times the compounding is applied.
For example, Ben, Alex, and Alia went to the same bank and deposited $100,000 each at the same time. The bank is providing 12% annual interest to all its customers. After one year, the three of them went to see how much their money grew.
Ben’s account has $112,000
Alex’s account has $112,683
Alia’s account has $112,747
Why is there a difference in the amount of money in these three accounts? What could be the reason?
The answer lies in how the compounding happened. Ben’s account is compounded annually, Alex’s account is compounded monthly, and Alia’s account is compounded daily. You can see that even though the deposit money is the same and for the same period, the number of times the money is getting compounded creates a major difference of close to 700 dollars.
Practice Question 1:
Brad lent $50,000 to Alina at a rate of interest of 6% per annum compounded daily. Alina is planning to return him the money after 45 days. What should be the money that Brad should receive from Alina?
Practice Question 2:
An annual interest rate of 11.5% compounded daily is better than an annual interest rate of 12% compounded annually. Prove whether true or false.
Practice Question 3:
Emily deposited $5000 in a fixed deposit. The bank gave 6% annual interest to her. Whenever Emily closes the fixed deposit, Emily will have to pay a tax of 15% on the interest amount that she gained. Emily withdraws the amount exactly after one year. What is the amount she encashes?
Practice Question 4:
Joe has to pay an outstanding balance of $4500 on his credit card. The credit card issuing bank applies 36.5% interest annually on the credit card. Joe has ignored and stopped paying any amount on his credit card. What is the amount that Joe owes to the bank on his credit card?
a). After 1 year (365 days)
b). After six months (183 days)
Discount Rate
It is the rate used to calculate the present value of a future cash flow. Intuitively, it is the exact opposite of calculating the future value. It is the rate at which we discount the future cash flows to arrive at the present value of the future cash flows.
While we were calculating future value by compounding the present value at an interest rate, in this case, we exactly do the opposite. We calculate the present value by dividing the future value with a discount rate (interest rate). While discount rates can actually be more complex, this is a basic introduction to its general use in finance for juniors.
Practice Problem 1:
A real estate developer is building apartments worth $500,000 each. The apartment will be ready to move in 2026. But, if you want to pay for the apartment in full, then how much should you pay now (assuming 2 years is the wait to occupy). Interest rate is 5% p.a.
Practice Problem 2:
Albano has a cheque from the State insurance fund for $5000 dated 31st July 2025. Albano wants to liquidate the cheque through another partner at 1% per month. How much money will the partner give him today (on 31st July 2024)?
In our financial literacy course for juniors, we cover key practical topics for juniors to learn early and develop intuition on time value of money, interest rates, discount rates, inflation, exchange rates, journal entries, ledgers, and more.
Hope this is useful, thank you.
You may like to read about: Financial Literacy for Juniors
