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The effect of compounding and Future Value

30 April, 2015 - 10:04

Due to the effect of compounding interest, large gains on principle can be achieved over a period of many years. For example, suppose one were to invest $100 at an interest rate of 7% for 20 years. Without compound interest, the total at the end of 20 years would be $240.

FVsimple interest =\ C\ +\ t(C*r)

However, when the interest earnings from one year are reinvested the next, the following formula is used:

FVcompound interest =\ C\,(1+r)^t

Substituting 100 for C, 0.07 for r, and 20 for t, we see that

FVcompound interest =\$100\,(1.07)^{20} = \$ 386.97

Clearly, compound interest enables significant gains over a period of many years.

The following diagram shows how $1 will become $10 after 47 years of 5% compound interest: