The comprehension of interest rates and their computation can be a challenging task even for “seasoned economists,” resulting in the misinterpretation of financial data. Fortunately, Truth Concepts Financial Calculators can facilitate rate calculations and make the process more straightforward. Let’s explore an example that illustrates how to determine if an annual interest rate of 12% is equivalent to a monthly interest rate of 1%.
The Power of Compounding
Is there a difference between 12% annual interest and 1% monthly interest? You may be tempted to say yes, but let’s take a look using a Truth Concepts Future Value Calculator.
To find out if 1% and 12% are the same, we’ve got to plug them into Future Value to see the effect the interest is going to have on the account. So, for the first example, let’s look at $100,000 with a 12% interest rate applied once per year. Below, you’ll see that at the end of one year, the account has grown to $112,000.
Now, let’s look at the same account, except that the interest is applied monthly at a rate of 1%. The result is just a little bit more than the account where interest is applied once per year.
So what’s the reason behind this? Compounding interest, of course.
Many people forget that cash in the bank compounds over time (there’s really no such thing as simple interest, but we’ll tackle that another time). Provided you leave your account to its own devices, the second you earn interest on something, the next time it earns interest, you’ll be compounding. By applying the interest monthly, you’re earning 1% on the original account balance, AND any interest that’s been applied to the account. If you were to stretch out this example, you’d see that the annual interest is compounding. Yet, it’s happening more slowly, because it’s only occurring once a year as opposed to 12 times a year.
What this proves is that even a “small” interest rate can have a BIG impact if it’s compounding monthly. No matter how far out you look at the above examples, you’ll see that the 1% monthly account stays ahead because it’s compounding more frequently.
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