You have been asked by your friend to describe this topic. Your friend knows very little about math, but learns well with pictures and analogies. Come up with a creative way to explain the concept of “compound interest” to your friend.
Go to http://bankrate.com/brm/calc/savecalc.asp. If you want to save $25,000 for a down payment on a house and you have ten years to save this amount, how much would you need to save monthly to achieve this goal if the interest rate is 5% compounded monthly.What happens if you can increase your interest rate to 8%? NOTE: Enter $100 for the “How much money can you spare for your first deposit or investment”. Come up with your own example of compound interest.
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A friend wants to understand the concept of compound interest by analogy so consider:
Each week, Kevin gives $5 to his father for safe-keeping but agrees that his father can "borrow" his $5 and any accumulated amount if he needs it as long as he can give Kevin his money back in December (say 10 months away). He begins paying his father.
After a few months (say 5 months- for the purposes of this explanation, a month is always 4 weeks), his father does indeed borrow the accumulated money (which is 5 months x 4 weeks = $100) and to show his gratitude, when he replaces it, he adds an extra $50. After this, each time the father borrows the money, he always adds extra when he replaces it. So when Kevin gets his money back in December, he receives the $200 that he "invested" plus the "interest" his father paid and, satisfied, walks away with $310.
At the same time, Kevin's cousin, Sammy has been putting his $5 per week in a tin under his bed. In December, when he counts his money, he has $200. His father is very proud of his ability to save and gives him an extra $50. Satisfied, he walks away with his $250.
Kevin's savings resembles the concept of earning compound interest, as interest accumulates on interest, such as Kevin's money as it increases and Sammy's saving represents the concept of simple interest when he receives his "interest" as one lump sum payment which does not affect his accumulated amount.
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