Compound Interest

Compound Interest
Suppose that the amount P is borrowed for N periods at the interest rate i. The amount that
must be repaid at the end of the N periods is P (1 + i) N; that is
This method of computing interest is called compounding. Compounding assumes that there
are N sequential one-period loans
The total interest on the loan over the N periods is
Ic is called compound interest. It is the standard method of computing interest where interest
accumulated in one interest period is added to the principal amount used to calculate interest in the
next period. The interest period used with the compound interest method is called the compounding
period.
Example
If you were to lend $100 for three years at 10 percent per year compound interest, how much interest
would you get at the end of the three years?
Effective and Nominal Interest Rates

Interest rates may be stated for some period, such as a year, while the computation of interest is
based on shorter compounding subperiods such as months.
Nominal interest rate is the conventional method of stating the annual interest rate. It is
calculated by multiplying the interest rate per compounding period by the number of
compounding periods per year. Suppose that a time period is divided into m equal subperiods.
Let there be stated a nominal interest rate, r, for the full period. By convention, for nominal
interest, the interest rate for each subperiod is calculated as is is = r/m. For example, a nominal
interest rate of 18 percent per year, compounded monthly, is the same as
Effective interest rate is the actual but not usually stated interest rate, found by converting a
given interest rate with an arbitrary compounding period (normally less than a year) to an
equivalent interest rate with a one-year compounding period. What is the effective interest rate,
ie, for the full period that will yield the same amount as compounding at the end of each
subperiod, is?
We want to find the effective interest rate, ie, that yields the same future amount F at the end
of the full period from the present amount P.
Example:
What is the annual effective interest rate equivalent to a nominal rate of 12 percent a year?
Ans. ie = 0.127 or 12.7 %
Example:
Leona the loan shark lends money to clients at a rate of 5 percent interest per week! What is
the nominal interest rate for these loans? What is the effective annual interest rate?
Example:
The Cardex Credit Card Company charges a nominal 24 percent interest on overdue accounts,
compounded daily. What is the effective interest rate?
Equivalence
Making these decisions requires that the costs and benefits at different times be compared. To
make these comparisons, we must be able to say that certain values at different times are
equivalent. Equivalence is a condition that exists when the value of a cost at one time is
equivalent to the value of the related benefit received at a different time
Mathematical Equivalence
Mathematical equivalence is simply a mathematical relationship. It says that two cash flows, P t
at time t and Ft+N at time t + N, are equivalent with respect to the interest rate, i, if Ft+N = Pt(1 + i)
N. Notice that if F
t+N+M (where M is a second number of periods) is mathematically equivalent to
Pt, then
Decisional Equivalence
For any individual, two cash flows, Pt at time t and Ft+N at time t + N, are equivalent if the
individual is indifferent between the two. Here, the implied interest rate relating P t and Ft+N can
be calculated from the decision that the cash flows are equivalent, as opposed to mathematical
equivalence, in which the interest rate determines whether the cash flows are equivalent
Market Equivalence
Market equivalence is based on the idea that there is a market for money that permits cash
flows in the future to be exchanged for cash flows in the present, and vice versa. Converting a
future cash flow, F, to a present cash flow, P, is called borrowing money, while converting P to F
is called lending or investing money. The market equivalence of two cash flows P and F means
that they can be exchanged, one for the other, at zero cost
Problem
You want to buy a new computer, but you are $1000 short of the amount you need. Your aunt
has agreed to lend you the $1000 you need now, provided you pay her $1200 two years from
now. She compounds interest monthly. Another place from which you can borrow $1000 is the
bank. There is, however, a loan processing fee of $20, which will be included in the loan
amount. The bank is expecting to receive $1220 two years from now based on monthly
compounding of interest.
Exercises
1. A loan for P50,000 is to be paid in 3 years at the amount of P65,000. What is the effective rate of
money?
a) 9.01 %
b) 9.14 %
c) 9.31 %
d) 9.41 %
2. What is the effective rate corresponding to 18% compounded daily? Take 1 year is equal to 360 days
A. 19.61 %
B. 19.44 %
C. 19.31 %
D. 19.72 %
3. What rate of interest compounded annually is the same as the rate of interest of 8% compounded
quarterly?
A. 8.07 %
B. 8.12 %
C. 8.16 %
D. 8.24 %
4. Which of these gives the lowest effective rate of interest?

A. 12.35 % compounded annually
B. 11.90 % compounded annually
C. 12.20 % compounded annually
D. 11.60 % compounded annually
5. Mandarin Bank advertises 9.5% account that yields 9.84% annually. Find how often the interest is
compounded.
A. Monthly
B. Bimonthly
C. Quarterly
D. Annually

Compound Interest

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Compound Interest

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Compound Interest

The total interest on the loan over the N periods is

Effective and Nominal Interest Rates

4. Which of these gives the lowest effective rate of interest?

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