Question

You are choosing between investments offered by two different banks. One promises a return of 10% for three years using simple interest while the other offers a return of 10% for three years using compound interest. You should: A) Choose the simple interest option because both have the same basic interest rate. B) Choose the compound interest option because it provides a higher return. C) Choose the compound interest option only if the compounding is for monthly periods. D) Choose the simple interest option only if compounding occurs more than once a year. E) Choose the compound interest option only if you are investing less than $5,000.

Answer 1

The correct option is B

Compounding Interest provides the higher return than simple interest

Explanation: In simple interest, The interest is charged only on the principal of the investment the number of periods will not increase or decrease the amount of simple interest. In Compounding interest, the interest is paid on the accumulated value of the principal and interest due which gives the higher return than the simple rate of interest.

For Example: Principal - 1000 and Interest rate - 10%, Time - 2 Years

Simple Interest = Principal * rate * interest

= 1000 * 10% * 2

= $200

In compund interest, = [Principal ( 1+Rate)^Number of Period] - Princpal

= 1000 ( 1+ 10%)^2 - 1000

= 1000 *(1.1)^2 - 1000

= 1210 - 1000

= $210

So, the interest on compounding interest is $210 which is higher than simple rate of interest of $200.