You invest $1,000 at 6% annual interest compounded annually. After 2 years, how much interest have you earned (rounded to the nearest cent)?
A$120.00
B$123.60
C$60.00
D$126.00
Year 1: $1,000 x 0.06 = $60 interest, balance = $1,060. Year 2: $1,060 x 0.06 = $63.60 interest, balance = $1,123.60. Total interest = $123.60. The key difference from simple interest ($120.00) is the $3.60 earned on Year 1's interest — that is the compounding effect. Option A ($120) is the simple interest answer, which is the most common error.
Question 2 True / False
Compound interest mainly benefits savers. Borrowers are not affected by compounding.
TTrue
FFalse
Answer: False
Compounding works identically for debt. Credit card balances, mortgages, and student loans all compound — meaning you pay interest on previously accumulated interest. A $5,000 credit card balance at 22% APR grows alarmingly fast if only minimum payments are made. Compound interest is a neutral mathematical force that amplifies both savings and debt.
Question 3 Short Answer
Explain why someone who starts saving $200/month at age 25 can end up with more money at 65 than someone who saves $400/month starting at age 35, assuming the same interest rate.
Think about your answer, then reveal below.
Model answer: The person starting at 25 has 10 extra years of compounding. Those early contributions earn interest for 40 years instead of 30, and the interest itself earns interest for longer. Exponential growth means time matters more than contribution size.
With 7% annual returns: $200/month for 40 years grows to roughly $528,000. $400/month for 30 years grows to roughly $489,000. The early starter contributes $96,000 in principal while the late starter contributes $144,000 — yet the early starter ends up with more. This is the most powerful practical lesson of compound interest: time is the dominant variable.