How does a compound interest rate differ from a simple interest rate?
A.
Compound interest rates pay more interest over time.
B.
Compound interest rates are calculated only once a year.
C.
Compound interest rates are usually lower than simple interest rates.
D.
Compound interest rates apply to home mortgages only.
A. Compound interest rates pay more interest over time.
Simple interest is calculated only on the principal amount, whereas compound interest is calculated on the principal amount as well as the accumulated interest over time. Therefore, compound interest rates will result in higher returns over time compared to simple interest rates.
The correct answer is A. Compound interest rates pay more interest over time.
To understand the difference between compound interest rates and simple interest rates, it is important to understand how they are calculated.
Simple interest is calculated on the initial principal amount or investment for a specific period of time. The interest is not reinvested or added back to the principal amount. So, for example, if you invest $100 with a simple interest rate of 5% per year for 3 years, you would earn $5 of interest each year ($100 x 5% = $5), resulting in a total interest of $15 over the 3 years.
On the other hand, compound interest is calculated not only on the initial principal amount but also on the accumulated interest from previous periods. This means that the interest earned is reinvested or added back to the principal amount, allowing for interest to be earned on interest. Using the same example as before, with a compound interest rate of 5%, in the first year you would earn $5 of interest, resulting in a new principal amount of $105. In the second year, you would earn 5% interest on $105, which would be $5.25, resulting in a new principal amount of $110.25. In the third year, you would earn 5% interest on $110.25, which would be $5.51, resulting in a final principal amount of $115.76. Hence, with compound interest, you would earn a total interest of $15.76 over the 3 years, which is more than what you would earn with simple interest.
Therefore, the correct answer is A. Compound interest rates pay more interest over time because they take into account the reinvestment of interest, allowing for interest to be earned on previous interest.
The correct answer is:
A. Compound interest rates pay more interest over time.
Compound interest is calculated on both the initial principal (the original amount of money) and any accumulated interest that has been added to it. As a result, the interest earned in each period is added to the principal, and in subsequent periods, interest is calculated on the new total. This compounding effect leads to higher interest payments over time compared to simple interest rates, which are calculated only on the principal amount.