How to Teach Compound Interest
Interest is either calculated as simple interest or compounded interest. Simple interest is a very easy calculation that bases the amount of interest on principal only. Compound interest, on the other hand, bases the interest amount on principal plus interest and is harder to calculate than simple interest. When teaching compound interest, first begin by explaining what simple interest is and how it is calculated. After that, begin to explain the definition of compound interest and how it is calculated using an example.
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Instructions
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Learn the formula for simple interest. Simple interest requires only one calculation and uses the formula: I = PRT; which stands for interest is equal to principal times rate times time.
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Calculate simple interest. The easiest way to learn how to calculate simple interest is by using an example. Calculate the interest on a loan that is $1,000, has a 5% interest rate and is for 3 years. Plug the numbers into the equation: I = ($1,000)(0.05)(3). This equals $150 of interest. Interest calculated this way is only calculated on the principal amount.
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Explain compound interest. When teaching compound interest, explain that interest is calculated more often and is based on principal plus accumulated interest. From the above example, if the interest was compounded annually, the interest amount would be higher.
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Calculate the first year of interest. Using the same formula, calculate the first year of interest by plugging in these numbers: I = ($1,000)(0.05)(1). Notice that all of the information is the same except for the last number which represents time. In this case, interest is calculated annually, so the "1" represents 1 year. The interest for the first year then is $50.
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Add the interest to the principal. When $50 is added to the $1,000 principal, the new balance is $1,050. This becomes the principal amount used to calculate the next years' interest amount.
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Calculate the second years' interest. Use the same formula, but substitute the new amount in to look like this: I = ($1,050)(0.05)(1). This amount is $52.50.
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Add this amount to the principal. When this is added the total amount is now $1,102.50.
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Calculate the third and final years' interest. The equation now looks like this: I = ($1,102.50)(0.05)(1). This answer is $55.13.
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Add the two amounts. Add $55.13 to $1,102.50 to get a total of $1,157.63. This amount minus the original principal is $157.63 which represents the total amount of interest for this loan.
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Compare the two numbers. Notice that when interest is compounded, it is higher. This is because with this method interest is being accumulated using the total balance and not simply just the principal amount.
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References
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