Compounding Interest and the Banker, business and finance homework help

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DISCUSSION QUESTION:

Compounding Interest and the Banker

There are many factors influencing the cost of money for both individuals and corporations. Suppose you deposit money in an interest bearing account and at the same time borrow a bit of money from the same bank.

  • In which account would the bank apply quarterly compounding factors versus simple interest?
  • Explain your choices and your reasoning. You may want to check your personal accounts in regard to this type of transaction.

STUDENT #1 RESPONSE:

If I were to deposit money in an interest bearing account, such as my current savings account, this account would earn compound interest. According to handsonbanking.org, "If account pays compound interest, that means the financial institution will pay you interest not only on your original deposit but also on the interest your deposit has earned over time. With compound interest, your money grows more — and a lot faster!" (2015). For example, every two weeks, I put $250 directly into my savings account. This means that monthly, I increase my savings account by $500. Over a month's time, my bank applies earned interest into my savings account. Though it is literally pennies at a time, the bank looks at the current amount that I have in my savings, and applies compound interest due to the amount at that time.

As for the account in which I am borrowing money from the same bank, this account would accrue simple interest. According to investopedia.com, "Simple interest is called simple because it ignores the effects of compounding. The interest charge is always based on the original principal, so interest on interest is not included" (2015). This means that if I were to borrow $5,000 at a 2% interest rate, the 2% could be a simple interest, and I accrue interest on the $5,000 that I originally borrowed.


Reference:
http://www.handsonbanking.org/financial-education/adults/the-power-of-compound-interest-2/


http://www.investopedia.com/terms/s/simple_interest.asp

STUDENT #2 RESPONSE:

The bank would apply quarterly compounding interest in a savings account because as you save money the interest will earn interest (Foreman, 2012). For example if  an account had $200 dollars and at the end of the quarter it had $5 earned in interest the following quarter it would earn interest on $205 as opposed to the original $200. Over time this would generate a much larger amount on interest earned then simple interest would.

If someone borrowed money for a car loan for example through a bank they would probably use simple interest this is because just as the amount earned in a savings plan would snowball the same would be true of the amount owed on a car loan if the interest was compounding. By using a simple interest rate the borrower is basically paying a flat percentage for the amount borrowed. Even though the loans are amortized so that the interest is frontloaded in the payment schedule the interest rate remains the same. It seems that if banks could get away with it and in order to maximize profits they would probably reverse the two scenarios so that compound interest is paid on a car loan and only simple interest is paid in a savings account.

Paul Boling

References:

Foreman, G. (2012). 10 Things you need to know about compound interest. Retrieved 04/21/2016 from http://money.usnews.com/money/blogs/my-money/2012/09/20/10-things-you-need-to-know-about-compound-interest


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