Compound Interest

A compound-interest contract is like a series of simple-interest contracts that are connected. The length of each simple-interest contract is equal to one compounding period. At the end of each period the interest earned on each simple-interest contract is added to the principal. For example, if you deposit 1,000.00 in a savings account that pays 6% annual interest, compounded monthly, your earnings for the first month look like a simple-interest contract

written for 1 month at 1/2 % (6% ÷ 12). At the end of the first month the balance of the account is 1,005.00 (5 is 1/2 % of 1,000).

The second month, the same process takes place on the new balance of 1,005.00. The amount of interest paid at the end of the second month is 1/2 % of 1,005.00, or 5.03. The compounding process continues for the third, fourth, and fifth months. The intermediate results in this illustration are rounded to dollars and cents.

Figure 3 Annual interest compounded monthly

The word compound in compound interest comes from the idea that interest previously earned or owed is added to the principal. Thus, it can earn more interest. The financial calculation capabilities of the HP 10bII+ are based on compound interest.

Interest Rates

When you approach a financial problem, it is important to recognize that the interest rate or rate of return can be described in at least three different ways:

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