Question

What concept describes how quickly an investment increases in value when interest is paid not only on the original amount invested, but also on the accumulated interest payments?

Answer 1

Answer:

Compound Interest

Step-by-step explanation:

When the interest is paid on principal amount only, then there is fixed return in case of a specified rate.

For example: Simple interest @ 5% on principal value of $100 shall be

$100 $\times$ 5% = $5 each year

Even though the interest amount is not withdrawn, and kept in the account earning this return.

Although, in case of compound interest:

Principal = $100

Rate = 5%

At the end of year 1, assuming interest is compounded each year

Value of interest = $100 $\times$ 5% = $5

Value of security or investment = $105

Second year interest = $105 $\times$ 5% = $5.25

Value = $105 + $5.25 = $110.25

Whereas in simple interest the value stays constant of principle on which interest is calculated = $100

Thus, total return in 2 years under simple interest  = $100 + $5 + $5 = $110

Whereas that in compounded interest, compounded annually = $100 + $5 + $5.25 = $110.25

Thus, value of money increases faster in compound interest.