Question 1

How does compound interest differ from simple interest?

Accepted Answer

Simple interest is calculated only on the original principal amount. Compound interest is calculated on the principal plus all previously earned interest. Over time, compounding creates a snowball effect. For example, $10,000 at 6% simple interest earns $600/year consistently. With annual compounding, it earns $600 the first year, $636 the second, $674 the third, and so on. After 30 years, compound interest yields $57,435 versus $28,000 with simple interest.

Question 2

What is the Rule of 72?

Accepted Answer

The Rule of 72 is a shortcut for estimating how long it takes an investment to double. Divide 72 by the annual rate of return. At 6%, money doubles in about 72/6 = 12 years. At 8%, it doubles in 72/8 = 9 years. At 10%, it doubles in about 7.2 years. This rule is a useful mental math tool for quickly assessing the power of different return rates and time horizons. It is most accurate for rates between 4% and 12%.

Question 3

Does compounding frequency matter?

Accepted Answer

Yes, more frequent compounding increases the effective return. A 6% annual rate compounded monthly produces an effective rate of about 6.17%, compared to exactly 6% with annual compounding. Daily compounding produces 6.18%. The difference between monthly and daily compounding is tiny, but the difference between annual and monthly can be meaningful over long periods. For large sums and long time horizons, choosing the right compounding assumption matters.

Question 4

How accurate are future value projections?

Accepted Answer

Future value calculations assume a constant rate of return, which rarely occurs in practice. Stock market returns fluctuate significantly year to year. The projection is best understood as an average expected outcome, not a guarantee. Use conservative return assumptions (5-7% for a diversified stock portfolio, 3-4% for bonds) and understand that actual results will vary. The calculation is most useful for comparing scenarios and setting savings goals.

Question 5

What rate of return should I assume?

Accepted Answer

The appropriate rate depends on your investment mix. Historical long-term averages: U.S. stocks about 10% nominal (7% real after inflation), bonds about 5% nominal (2% real), savings accounts 1-5% depending on interest rate environment. For conservative planning, use inflation-adjusted (real) returns. For aggressive planning, nominal returns are appropriate but remember they overstate purchasing power growth. Most financial planners use 6-7% as a balanced assumption.

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