Compound Interest 1

2.
1
COMPOUND INTEREST
With simple interest, we were assuming that we pocketed the interest when we received
it. In a standard bank account, any interest we earn is automatically added to our balance, and
we earn interest on that interest in future years. This reinvestment of interest is called
compounding.
Compound interest is defined as interest on interest.
The accumulated amount at the end of the period, the
original principal and the compound interest, is called the
final amount or maturity value. The number of interest
periods for one year is designated by m, while the total
number of interest periods for the whole investment term is
designated by n, where n = t x m
The frequency of conversion per year are is denoted by m: such as monthly (m = 12),
quarterly (m = 4), semi-annually (m = 2) and annually (m = 1). The rate of interest is usually
stated as an annual rate, by “interest or money worth 12%” means 12% compounded annually.
Otherwise, the frequency of conversion will always be indicated, such as 8% compounded
quarterly, 3% compounded monthly, etc.
Example 1: Determine the compound amount and the compound interest of 100,000.00 for
one year at 6% compounded quarterly. For this example, we will use the long
method to see how compound interest works.
Interest every 3 months Amount at the end of every 3 months

I3 =P 100,000(3/12)(.06)=P 1,500 F3= P 100,000+ P 1,500= P 101,500
I3=P 101,500(3/12)(.06)= P 1,522.5 F3= P 101,500+ P 1,522.5=P 103,022.5
I3=P 103,022.5(3/12)(.06)=P1,545.34 F3= P 103,022.5+P1,545.34=P 104,567.84
I3= P 104,567.84(3/12)(.06)=P 1,568.52 F3= P 104,567.84+P 1,568.52=P106,136.36
A compound interest formula, which will provide us with a simpler and easier solution in
computing the compound amount and the interest, should be used.
The Compound Amount (F) and Compound Interest (I)
Let P be the original amount of principal invested in rate I each interest period and F the
compound amount at the end of n periods.
P = original principal
Pi = interest in the first period
P + Pi = new principal at the end of 1 period
P(1 + i)i = interest in the second period
P(1 + i)i + P(1 + i)i = P(1 + I)2 = new principal at the end of the second period
P(1 + i)2i = interest in the third period
P(1 + i)2 + P(1 + i)2 = P(1 + i)3 = new principal at the end of the third period
When this idea is extended, the compound amount at the end of the nth period may be expressed
as:
where:
F = compound amount
P = original amount
m = conversion period
j= nominal rate
i = interest per conversion period which is equal to nominal rate (j) divided by the
conversion period (m) [ i = j/m)
n = total number of conversion periods for the whole term (n = t x m)
Example 2: Determine the compound amount and the compound interest if P250,000.00 is
invested at 10% compounded quarterly for 4 years.
Solution:
Given: P = P250,000.00
m=4
j = 10%
i = j/m = 0.10/4 = 0.025
t = 4 years
n = t x m = 4 x 4 = 16
Find: F, I
Example 3: Neil Frank deposits P300,000 in a bank which earns interest at 15% compounded
monthly. Assuming no withdrawals will be made, how much would he have at the
end of 5 years?
Solution:
Given: P = P300,000.00
m = 12
j = 15%
i = j/m = 0.15/12 = 0.0125
t = 5 years
n = t x m = 5 x 12 = 60
Find: F
Example 4: Accumulate P5,000 for 4 years and 4 months at 18% compounded bimonthly.
Solution:
Given: P = P45,000.00
m=6
j = 18%
i = j/m = 0.18/6 = 0.03
t = 4 years and 4 months
n = t x m = 4 x 6 = 26
Find: F
45,000(1+0.03)26
6.216%
 6.21%
6.200001%=6.2%
P3651.208PP3651.21
3651.200832645515  P3651.20
36512.000832645515  P36512
Example 5: Determine the compound interest at the end of 5.5 years if Ms. Alpajora invests
P20,000 which pays interest at 14.75 compounded semi-annually.
Solution:
Given: P = P20,000.00
m=2
j = 14.75%
i = j/m = 0.1475/2 = 0.07375
t = 5.5 years
n = t x m = 5.5 x 2 = 11
Find: F, I
F= P
n
j
F=P(1+ )
m
n
j
P=F /(1+ )
m
−n
j
P=F (1+ )
m
PRESENT VALUE
The present value of compound interest of given sum of money is the principal (P)
which, if invested now at the given rate, would amount to (F) after n interest period. To
discount an amount F for n conversion periods means finding its present value P
From F = P(1 + i)n, the present value P can be computed by:
P = F(1 + i)-n
and the compound discount (D) can be obtained by:
D=F–P
Example 1:
In order to have P50,000 in 5 years, how much should you invest now at 18% compounded
semi-annually?
Solution:
Given: F = P50,000
m =2
j = 18%
i = j/m = 0.18/2 = 0.09
t = 5 years
n = t x m = 5 x 2 = 10
Find: P
P = F(1 + i)-n
= P50,000(1 + 0.09)-10
= P50,000(0.422411)
P = P21,120.54
Example 2: Find the present value of P12,000 due at the end of 5 years at 13% compounded
quarterly.
Solution:
Given: F = P12,000
m=4
j = 13%
i = j/m = 0.13/4 = 0.0325
t = 5 years
n = t x m = 5 x 4 = 20
Find: P
P = F (1 + i)-n
= P12,000(1 + 0.0325)-20
= P12,000(0.527471)
P = P6,329.66
Example 3: How much should you invest now in order to raise P450,000 after 4 years and 6
months if money is worth 6% compounded semi-annually?
Solution:
Given: F = P450,000
m=2
j = 6%
i = j/m = 0.06/2 = 0.03
t = 4.5 years
n = t x m = 4.5 x 2 = 9
Find: P
P = F(1 + i)-n
= P450,000(1 + 0.03)-9
= P450,000(0.766417)
*** P = P344,887.53

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Interest every 3 months Amount at the end of every 3 months

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