Question

Which of the following alternatives would a logical and sensible investor choose?

A. Borrow money with an interest rate of 7% with monthly compounding, rather than borrowing money with an interest rate of 7% with annual compounding

B. Invest money with an interest rate of 5% with annual compounding, rather than investing money with an interest rate of 5% with monthly compounding

C. Borrow money with an interest rate of 9% with quarterly compounding, rather than borrowing money with an interest rate of 9% with semiannual compounding

D. Invest money with an interest rate of 5% with quarterly compounding, rather than investing money with an interest rate of 5% with semiannual compounding

Answer 1

Compounding in simple term means Interest on Interest. Interest will be charged on outstanding balance of Principle + till date interest.

In case of Borrowing Long duration compounding is preferable rather than lower duration e.g. Yearly instead on quarterly as in case of Quarterly compounding, Interest in next quarter includes interest on interest of previous quarter.

In case of Investment lower duration Compounding is preferable rather than longer duration e.g. monthly rather than semi-annually. This will help to gain interest on previous month’s interest portion also

Evaluate the options now :

A. Borrow money with an interest rate of 7% with monthly compounding, rather than borrowing money with an interest rate of 7% with annual compounding

Since it is borrowing long duration compounding is preferable rather than short, hence option is not logical

B. Invest money with an interest rate of 5% with annual compounding, rather than investing money with an interest rate of 5% with monthly compounding

Since it is investment Short duration compounding is preferable rather than long duration, hence option is not logical

C. Borrow money with an interest rate of 9% with quarterly compounding, rather than borrowing money with an interest rate of 9% with semiannual compounding

Again it is borrowing long duration compounding is preferable rather than short, hence option is not logical

D. Invest money with an interest rate of 5% with quarterly compounding, rather than investing money with an interest rate of 5% with semiannual compounding

Since it is investment Short duration compounding is preferable rather than long duration, here we are investing in quarterly compounding investment rather than semi annually means it is logical & sensible option.

Option D is right.

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