Compound interest eli5:
Hello,
So I am little confused, I know that compound interests is interests on interests. But how you achieve it? Say that I invest 100 dollars in a Roth IRA in a eft fund that pays 2% dividends, after a year it grows to 102 dollars(plus appreciation with is like 7%) so like after a year I “have” around 110 dollars and as years go on this cycle repeats? Is this what compounding is in ROTH Ira?
In: Economics
When someone says compounding interest they’re talking about “how frequently the interest gets paid out and added back into the running total”.
Let’s say you have:
an interest rate of 10% ANNUALLY
your money compounds ANNUALLY
The calculation is simple:
$100 X 10%
$110 TOTAL BALANCE
Alternatively, let’s say you have:
an interest rate of 2% ANNUALLY
your money compounds QUARTERLY [every 3 months]
The calculation is more complex:
$100 X 10% X 3/12 months
$100 + 2.50 interest
$102.50 X 10% X 3/12 months
$100 + 5.06 interest earned
$105.06 X 10% X 3/12 months
$100 + 7.69 interest earned
$107.69 X 10% X 3/12 months
$100 + 10.38 interest earned
$110.38 TOTAL BALANCE
You’ll notice that it doesn’t make a huge difference. Unless you have a high interest rate [10% or more] or a high balance [$1 million +] then daily compound interest doesn’t mean much compared to annual compounding interest.
For example,
if you had $1 million
at 10% annual interest
compounding daily
it would be $105,155 interest per year instead of $100,000 per year.
Other example,
if you had $1 million
at 2% annual interest
compounding daily
it would be $20,200.78 interest per year instead of $20,000 per year.
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