Question

Becoming a Millionaire The compound interest formula can be rewritten as \(P=\frac{A}{(1+r / n)^{n t}}\) Find the principal amount \(P\) that would have had to have been invested on the day you were born at \(7.5 \%\) annual interest compounded quarterly to make you a millionaire on your 21 st birthday.

Short answer

The principal amount P needed to be invested on the day you were born to make you a millionaire by your 21st birthday is calculated using the provided information and the compound interest formula. After carrying out the necessary calculations, you find the value of P.

Step-by-step solution

Understand and Interpret the Given Information

According to the problem, the annual interest rate (r) is 7.5% or \(0.075\) when converted to decimal. The number of times interest is compounded per year (n) is 4 (quarterly). The total time the money is invested or borrowed for (t) is 21 years, as it's the length of time until your 21st birthday. The total amount (A) is 1,000,000, as the goal is to become a millionaire.

Substitute The Values Into The Formula

We can now substitute the given values to the formula. Therefore, \(P=\frac{A}{(1 + \frac{r}{n})^{n*t}}\) becomes \(P= \frac{1,000,000}{(1+ \frac{0.075}{4})^{4*21}}\).

Calculate the Result

In order to solve for P, calculate the expression on the right side of the equation. Do the operations in the parentheses first, then raise the result to the proper power, and finally divide 1,000,000 by the obtained result to find the principal amount P.

Key concepts

Principal Amount

The principal amount is the initial sum of money that you invest or start with in a savings account. In the realm of investments, the principal is crucial because it determines the base on which future interest is calculated. When planning to achieve a financial goal, such as becoming a millionaire, identifying the right principal amount is vital.

To calculate the principal needed to become a millionaire by your 21st birthday, we use the rearranged compound interest formula:

• \( P = \frac{A}{(1 + \frac{r}{n})^{n \cdot t}} \)

In this equation, \( P \) represents the principal amount you need to invest today. It accounts for interest rates, the frequency of interest compounding, and the total time frame of the investment.

Knowing the principal amount can guide your investment decisions and help you plan for your financial future.

Annual Interest Rate

The annual interest rate is a key factor in calculating compound interest. It is the percentage of interest gained or paid on an investment or loan each year. In simple terms, it determines how much extra money an investment earns within a year.

In our example, the annual interest rate is 7.5%, which means that each year, the investment grows by 7.5% due to interest. To use this rate in our formula, it's converted to a decimal form, which is \(0.075\).

• The higher the interest rate, the faster your investment grows.
• A lower interest rate results in slower growth.

Understanding the impact of different rates can aid you in selecting the best investment options. It also helps in setting realistic financial goals based on achievable interest earnings.

Compounding Quarterly

Compounding is the process where the investment earns interest, and then that interest itself earns interest as well. Compounding quarterly means that the interest is calculated and added to the principal amount four times a year.

Compounding more frequently generally results in higher returns compared to less frequent compounding, due to multiple periods for interest to accumulate in a year.

• When the compounding frequency is high, even a small principal amount can grow significantly over time.
• Quarterly compounding translates to interest being applied every three months.

In our calculation, the value of \( n \) is 4, which indicates that the interest is compounded quarterly. This high level of compounding helps reach the financial goal faster compared to annual or semi-annual compounding.

Investment Calculation

Investment calculation involves figuring out the final worth of an investment, taking into account various factors like the principal, interest rate, and compounding period.

To accomplish successful investment calculation, especially for reaching milestones like a million-dollar goal by age 21, several steps must be followed:

• Identify all necessary inputs: principal (\(P\)), interest rate (\(r\)), compounding frequency (\(n\)), and time period (\(t\)).
• Substitute these values into the compound interest formula: \( P = \frac{A}{(1 + \frac{r}{n})^{n \cdot t}} \).
• Perform calculations methodically: start with operations inside parentheses, resolve any exponents, and finally compute the full expression.

By understanding and applying these steps correctly, investment goals can be approached strategically, increasing the likelihood of achieving desired financial success.