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Why is compounding an important consideration when calculating PV and FV problems? If you were given...

  1. Why is compounding an important consideration when calculating PV and FV problems? If you were given the choice between two bank savings accounts that pay the same interest rate, however, one compounds monthly, and the other semi-annually: which would you choose and why?
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Answer #1

The concept of compounding interest means calculating interest for interest. The higher the compounding period, the higher the impact of the same on cash flows.

Future Value = Present Value*(1+interest rate)^n

The compounding method gives us the discount factor for calculating the future value of present cash flow or to calculate back the present value of the future cash flows.

If given a choice between monthly and semi-annualy interest paying saving account, I would prefer monthly option as the compounding impact will be higher for monthly than for semi-annual. In semi-annual, interest is compounded 2 times in a year. However, in a monthly payment option, the interest is compounded 12 times(every month). The annual return will be higher in case of monthly payment structure.

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