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9.0: Introduction

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    38372
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    Do you dream of owning a home? What about a car or a home theatre system? Big purchases such as these require long-term financial planning. Compound interest means that you will pay substantially more money for your purchases or earn more money on investments than you would with simple interest.

    Compound interest is used for most transactions lasting one year or more. In simple interest, interest is converted to principal at the end of the transaction. Therefore, all interest is based solely on the original principal amount of the transaction. Compound interest, by contrast, involves interest being periodically converted to principal throughout a transaction, with the result that the interest itself also accumulates interest. How significant is the interest when it compounds? Let’s examine your big purchases from above:

    • A home theatre system with the big-screen TV, Blu-Ray player, stereo surround sound, and more can retail for $5,000. Did you know that if you put that amount on the retail store's 18% interest credit card and pay it off monthly for three years, you will pay over $1,500 of compound interest?
    • The average Canadian new car price is $25,683.1 Unless you have cash, you will join the ranks of other Canadians in taking six years to pay it off through $450 monthly payments, resulting in almost $7,000 of compound interest charges!
    • The average Canadian home price is $365,000,2 though of course it varies widely across our country. If it takes 25 years to pay off your mortgage at 6% interest, your $365,000 house becomes a $700,000 acquisition thanks to compound interest. That is almost twice the original price!

    And it is not any different for businesses. Whether they are local companies or multinational conglomerates they must invest and borrow at compound interest rates in their attempt to achieve long-term financial strategies. Some examples of these business activities include the following:

    • Borrowing $480,000 to open a new Tim Hortons’ single restaurant franchise operation.3
    • Spending $1,000,000 on a fleet of rigs and semi-trailers for product distribution.
    • Constructing new production plants or warehouses costing $10,000,000 or more.

    The money for these types of transactions does not appear out of thin air. It must be borrowed or taken from savings, and either approach involves compound interest.

    Throughout the rest of this textbook, you will study compound interest as it relates to three distinct but interconnected concepts.

    1. Calculating interest on a single amount (called a lump-sum amount or single payment). Chapter 9 introduces the basic mathematics, which are applied in Chapter 10.
    2. Calculating interest on a series of regular, equal payments, called annuities. Chapter 11 introduces the basic mathematics, which are applied in Chapter 12.
    3. Specialized applications including amortization, mortgages, bonds, sinking funds, and internal rates of return are covered in Chapter 13 through Chapter 15.

    Now turn the page to get started with the basics.

    References

    1. Statistics Canada, New Motor Vehicle Sales, June 2011 (Catalogue no. 63-007-X, p. 15), accessed August 18, 2013, http://publications.gc.ca/collection...011006-eng.pdf.
    2. The Canadian Real Estate Association, “National Average Price Map,” accessed September 27, 2013, crea.ca/content/national-average-price-map.
    3. Tim Hortons, “Frequently Asked Questions,” accessed May 13, 2010, http://www.timhortons.com/ca/en/join...se_ca_faq.html.

    Contributors and Attributions


    9.0: Introduction is shared under a not declared license and was authored, remixed, and/or curated by LibreTexts.

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