Question

Financial contracts involving investments, mortgages, loans, and so on are based on either a fixed or a variable interest rate. Assume fixed interest rates. Katherine deposited $500 in a savings account at her bank. Her account will earn an annual simple interest rate of 6.6%. If she makes no additional deposits or withdrawals, how much money will she have in her account in 13 years If Katherine's savings account earns 6.6% compounded annually, all other things being equal, how much money will Katherine have in her account in 13 years Suppose Katherine had deposited $500 in a savings account at a second bank at the same time. The second bank also pays a nominal interest rate of 6.6% but with quarterly compounding, Keeping everything else constant, how much money will Katherine have in her account at this bank in 13 years _____

Answer 1

Answer:

Simple interest saving account: $929

Annual compound interest account: $1147.66

Quarterly compound interest account: $1,170.99

Explanation:

There are simple equation you can use the compute the amount of money you will have when each of the three situations given in the questions are applied. The following illustrates for each scenario.

Simple Interest Rate Scenario

Simple interest is the interest rate that is applied only on the original principal amount. So in this scenario, the 6.6% interest is rate is the rate of interest that Katherine will continue to get on her initial deposit of $500 only even though the balance in the account will increase each year by the amount of interest rate she receives. So after 13 years, 13 years worth of interest will be applied on the original deposit.

The mathematical equation is: FV = P x (1 + RT)

Where, FV is the future value, P is the principal amount, R is the interest rate and T is the time period. When we plug in the values the equation would become:

FV = 500 x [1 + (0.066 x 13)] = $929

Annual Compound Interest Scenario

Compound interest, as opposed to simple interest, is a situation in which the interest rate is being applied on the available balance in the account. So, this balance would include the amount of interest accumulated over prior periods as well. So each year, 6.6% will be applied on the $500 PLUS the amount of interest accumulate.

The mathematical formula includes the same variables but is different in that, FV = P x (1 + R)^T.

Plugging in the values, FV = 500 x (1 + 0.066)^13 = $1,147.66

Quarterly Compounded Interest Scenario

This is similar to the annual compound interest scenario in that interest is applied on both the principal and the prior years' accumulated interest but rather than being applied annually, it will be applied quarterly.

The mathematical formula is FV = P x (1 + $\frac{R}{N})^{T x N}$. The new variable added is "N" which refers to the number of times the interest is compounded which in the question's context is 4 (quarterly compounding).

So the formula becomes, FV = 500 x (1 + $\frac{0.066}{4})^{13 X 4}$ = $1,170.99