Question

Your grandmother is choosing between investing in two alternative securities. One
investment pays 4% simple interest, and the other pays 3.75% interest, compounded
annually. Both investments are for 10 years and are similar in every other way (i.e.
risk level). She is leaning towards the 4% investment because of the higher interest
rate. In your efforts to help her decide, how would you explain why the 3.75%
investment is the better choice?

Answer 1

The best way to explain why the 3.75% option is a better choice would be to show a demonstration which explains the concept of compound interest.

Show her an example using an investment of $100 for 10 years.

Investment using simple interest

= Amount x ( 1 + rate x time)

= 100 x ( 1 + 4% x 10)

= $140

Investment using compound interest

= Amount x ( 1 + rate) ^ number of periods

= 100 x ( 1 + 3.75%)¹⁰

= $144.50

The investment using compound interest yields more returns because the interest earned increases every year on account of the interest being reinvested. This is as opposed to simple interest that is the same every year.

Find out more on compound interest at https://brainly.com/question/19640294.