Question

Would you rather have a savings account that pays 5% compounded annually, or an account that pays 5% compounded monthly? Be sure to explain your position here.

Answer 1

A savings account that pays 5% compounded monthly will be preferred. The higher the compounding frequency, the higher interest amount we will get.

For example. we deposit $1,000 is 2 savings account. one pays 5% compounded annually and other pays 5% compounded monthly. in the first savings accounts compounding frequency is once in a year where as in the second savings accounts frequency is 12 times in a year.

Value after one year of savings accounts paying 5% compounded annually = saving amount*(1 + interest rate/n)^n*t

n is no. of frequency and t is the time period.

Value after one year of savings accounts paying 5% compounded annually = $1,000*(1+0.05/1)^1*1 = $1,000*1.05 = $1,050

Value after one year of savings accounts paying 5% compounded monthly = $1,000*(1+0.05/12)^12*1 = $1,000*(1+0.00417)¹² = $1,000*1.00417¹² = $1,000*1.0512 = $1,051.2

So, we can see from above calculation that savings accounts that pays 5% compounded monthly has higher value after one year.