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Suppose you deposit $1,000. The interest rate is 5%. How much will you have two years...

Suppose you deposit $1,000. The interest rate is 5%. How much will you have two years from now? What is the effect of compounding?

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Answer #1

If we deposit $1000 and the interest rate is 5%, then the first year total cumulative amount including the interest shall be:

=1000*1.05 = 1050

For next year, interest will also be provided on the extra 50 interest earned in the previous year, hence total shall be:

=1050*1.05= 1102.50

Effect of compounding is we got interest on interest, which would not be possible in case of simple interest, capital grew to:

=1102.5-1000 = 102.50

If there was no compounding that interest earned would have been equal to $100, due to compounding interest is $2.5 more

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