Question

Which do you prefer: a bank account that pays 8% per year (EAR) for three years or:

(i) An account that pays 4% every six months for three years?

(ii) An account that pays 12% every 18 months for three years?

(iii) An account that pays 0.8% per month for three years?

Answer 1

This question shows the effects of compounding.

As the no. of compounding increases the future value of value of investment at maturity also increase,

Therefore the option 3 is most beneficial as it will result in higher maturity value.

Assuming we are investing $100 for 3 years
Option -	Compounding	No. of compounding(In 3 years)	Interest rate	Compounding Factor	Maturity value = 100 x Compounding factor
1	Annual	3	8%	(1.08)^3	125.9712
2	Semi Annual	6	4%	(1.04)^6	126.5319
3	Every 18 month	2	12%	(1.12)^2	125.44
4	Monthly	36	0.80%	(1.008)^36	133.223
As we can see the maximum return is under Monthly compounding Therefore it should be selected.
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