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
I’m not sure what that specific case is, but here’s the maths in general:
So, the idea with compound interest is that you get interest on interest. Say you had £100 in an account that got 20% interest each year, for 5 years. The naïve approach would be to say you get 5 lots of interest, so you’d get an extra 5×20%=100%. But, each year, you gain interest, meaning the amount in the account that you earn interest on increases. After each year, you have 120% (or 1.2 as a decimal) of what you had the year before.
After year 1: 1.2×100=£120
After year 2: 1.2×120=£144
After year 3: 1.2×144=£172.80
After year 4: 1.2×172.8=£207.36
After year 5: 1.2×207.36=£248.83
You’ve got an extra £48.83 compared to linear interest (where you’d earn £20pa).
The quick way to calculate this is to work out the decimal version of what you have after each interest period (in this case 1.2), then raise it to the number of interest periods, then multiply that by the original amount.
So 100×1.2⁵=248.83.
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