Question
You have just received a bonus of 15,000 euros and have decided that you want to invest the
money. After discussing your options with your bank, you have narrowed it down to two options:
A. A savings account that provides 7% simple interest annually.
B. A savings account that provides 6.25% compounded interest annually.
Assume that the deposit is made in year 0 and payments are made at the end of periods with first
payment end of year 1.
Answer the following:
1. What is the difference between simple and compounded interest?
2. You have decided to leave the money in the account for 12 years. Which option should you
choose?
3. In which year does option B become more favorable than option A?
Expert Answer
A) Simple interest means interest accured on the principal amount clubbing considering interest already earned for that principal. The bank Considers only Principal outstanding while calculating interest pay out. while in compound interest method bank will consider principal and interest outstanding at the time of interest or principal Payment.
precisely compound interest means Interest on interest earned and Initial Principal.
B)
| 15000 | Prinicpal O/s | Simple int | Compound | Aggregate simple | Aggregate compound | Compound Closinf | ||
| 0 | 0 | |||||||
| 1 | 15000 | 1050 | 937.5 | 1050 | 937.5 | 15937.5 | ||
| 2 | 15000 | 1050 | 996.0938 | 2100 | 1933.59375 | 16933.59375 | ||
| 3 | 15000 | 1050 | 1058.35 | 3150 | 2991.943359 | 17991.94336 | ||
| 4 | 15000 | 1050 | 1124.496 | 4200 | 4116.439819 | 19116.43982 | ||
| 5 | 15000 | 1050 | 1194.777 | 5250 | 5311.217308 | 20311.21731 | ||
| 6 | 15000 | 1050 | 1269.451 | 6300 | 6580.66839 | 21580.66839 | ||
| 7 | 15000 | 1050 | 1348.792 | 7350 | 7929.460164 | 22929.46016 | ||
| 8 | 15000 | 1050 | 1433.091 | 8400 | 9362.551424 | 24362.55142 | ||
| 9 | 15000 | 1050 | 1522.659 | 9450 | 10885.21089 | 25885.21089 | ||
| 10 | 15000 | 1050 | 1617.826 | 10500 | 12503.03657 | 27503.03657 | ||
| 11 | 15000 | 1050 | 1718.94 | 11550 | 14221.97635 | 29221.97635 | ||
| 12 | 15000 | 1050 | 1826.374 | 12600 | 16048.34988 | 31048.34988 | ||
| Total interest | 12600 | 16048.35 |
Thus Total Interest earned Option B is more than Option A i.e 16048.35 > 12600 Option B must be choosen.
C)Option B is favourable from the Year 5 as highlighted in the above table.
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