If your bank offers a 5% annual rate of return compounded annually, then at the end of one year your $1,000.00 deposit would grow by $50.00 to $1,050.00
However, in the second year, your deposit would increase by $52.5025 to a total ending value of $1,102.50. Explain why the second year earns more interest on the investment than the first year.
What will be an ideal response?
Answer: The student should understand that in the second and subsequent years the investment is earning interest on the interest already earned in the earlier period, as well as interest on the initial principal. Thus, in each period the $1,000.00 initial investment earns $50.00 and in the second year the interest earned on the interest is ($50.00) ∗ (.05) = $2.50.
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