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Compound Interest
Money doesnt grow on trees.
While this is true, money does make
more money, if it collects interest.
Interest is money that one pays for the
use of someone elses money.
Most people know that if you put
money in a bank, you will get more
money over time. The bank is paying
you to use your money for
investments and loans.
The longer the money is in the bank, the more money you will get. And it makes
sense that if you get put your money in a bank with high interest, you will get more
money than if you put it in a lower interest bank. But how does it all work? Lets
investigate.
To begin, we need to define some terms. When a person deposits money in a bank,
that initial amount is called the principal and is typically denoted by the letter P. The
rate at which that the principal collects interest is called the interest rate and is
denoted by the letter r. (The rate is typically expressed as a decimal and not as a
percentage.) While all of this is going on, time elapses, and is denoted by t.
There are two types of interest: basic interest and compound interest. Basic interest
is paid only once. For example, you may lend $100 to a friend and ask for 10% (0.1)
interest every year until you are repaid. If your friend pays you back in two years,
your friend will owe you $120, but why?
Your friend is responsible for paying back the initial amount, the principal, as well
as paying 10% on that principal for two years. 10% of $100 is $10, and times two
years is $20. So your friend will pay you $100 + $20 = $120. This reasoning is
summarized in the following formula.

Basic Interest Formula


If a principal of P dollars is borrowed for t years at an annual interest rate of r, then the
interest, I, will be
(1)

The interest charged according to formula (1) is called basic interest.


Compound interest, on the other hand, is interest paid on previously earned
interest. Suppose, instead of paying 10% interest when the money is given back, you
have your friend pay you 10% on the money he still has every year. If he doesnt pay
you back for two years, then you will get 10% on $100 the first year, which is $110
and you will get 10% on $110, which is $121 at the end of the second year. Instead of
getting $20, you will get $21. Another example might help explain this concept.
Example 1:
Suppose a bank offers an interest rate of 6% per annum (yearly) on a savings
account that is compounded quarterly (four times a year). A person deposits $4,000 in
the bank. How much money will be in his account at the end of one year?
Solution:
Since the interest is compounded quarterly, we can use the formula for basic
interest,
, four times. The principal amount P is $4,000, the interest
rate r is 6% (r = 0.06), and t =

of a year. (Recall that t is measured in years.)

So, the amount of interest earned on the savings account is:

Now, as we start the second quarter, the principal is no longer $4,000. Since we
have accumulated interest, the new principal is $4,000 + $60 = $4,060. Using that
new principal, the interest gained in the second quarter is:

The interest paid at the end of the third quarter on the principal of $6,060 + $60.90
= $6,120.90 is:

The final amount of interest paid, at the end of the fourth quarter, will be equal to:

.
Adding that interest amount to the principal going into that period ($4,182.71), we
get the balance in the account after one year. It will be $4,182.71 + $62.74 =
$4,245.45.
We can use the process above to obtain a general formula for computing compound
interest. To do this, notice that we started with a principal, P, and an interest rate r per
annum. Let n be the number of times the principal is compounded. Then the interest
earned at the end of each compounding period will be the principal amount times the
interest rate times the fraction , ie
one compounding period will be:

. The amount A in the account after

.
After two compounding periods, the amount A, based on the new principal
of

will be:

.
After three compounding periods, the amount will be:

.
Following this pattern, after n compounding periods, the amount A will be:
(2)

However, the above formula only works for interest compounded n times in one
year. In the more general case with t years, the principal will compound nt times. So,
we have the following formula.
Compound Interest Formula
The amount A after t years with a principal P and a per annum interest rate r,
compounded n times per year is:
(3)

If we rework Example 1 using formula (3), we would use P = $4,000, r = 0.06, n =


4, and t = 1. Plugging that in yields:

, which is what we found it to be above


using the longer, more tedious method of computing the amount after each period.
Now lets examine the effect that using different compounding periods has on the
amount of a principal investment after 1 year.
Example 2:
Let P = $1,000 be an initial deposit into a savings account with a per annum
interest rate of r = 0.05 (5%). What is the amount in the account after 1 year if the

account (i) compounds annually, (ii) compounds quarterly, (iii) compounds monthly,
(iv) compounds weekly, (v) compounds daily?
Solution:
(i)

Compounded annually:

(ii)

Compounded quarterly:

(iii)

Compounded monthly:

(iv)

Compounded weekly:

(v)

Compounded daily:

Notice that as the number of compounding periods increases, so does the ending
amount. With only one compounding period, the amount is $1,050. If the account
compounds daily, the ending amount is $1,051.27. While not significantly higher (it is
only $1.27 more), it is better than compounding only once. But what happens as
?
To find the answer, we need to rewrite formula (2).
(4)

Where the substitution

was used. Notice that as

as well.
Recall that the
,
.

. So, Eq. (4) tells us that as

If the amount A after 1 year of a principal P and a per annum interest rate r is
, then we say that the interest is compounded continuously. Again, the above
formula only holds if we are dealing with 1 year. Below is the general case for t years:
Continuous Compounding Interest Formula
The amount A after t years with a principal P and a per annum interest rate of r compounded
continuously is:
(5)

The following table compares different values of n and r with a principal of $1.
That means that we are using the formula:
the values in the table get closer to
.

. Notice that as n gets larger,

Table 1

Example 3:
Suppose that a savings account is compounded continuously at a rate of 8% per
annum. After three years, the amount in the account is $2,500. How much was
deposited at the beginning, assuming that nothing was added or withdrawn during that
period?
Solution:
We are told that account is compounded continuously, so we are going to
use
. Also, we know that the interest rate is 8% per annum, so r = 0.08.
The amount A is $2,500 when t = 3. All that is left is to find P. We can do that if we
plug in everything that we know.

Example 4:
Suppose that a savings account is compounded continuously with a principal of
$1,500. After 20 years, the amount increased to $5,000. (a) What was the per annum
interest rate, assuming that nothing was added or withdrawn during that period? (b) If
the account sits for another 20 years, how much will be in the account?

Solution:
To answer (a) we need to find the value of r. We are told that P = $1,500 and that
when t =20, A = $5,000. Using

, we can solve for r.

Now, (b) asks us to find out how much money will be in the account after another
20 years. Notice that means that t = 40, not 20. Using the same formula, keeping P the
same, but replacing r with 0.06 and t with 40 gives us the following:

When dealing with interest, the terms nominal interest rate and effective interest
rate arise. Dont let the terms confuse you. The nominal interest rate is just the per
annum interest rate, r, as it is used in the basic interest formula.
The effective interest rate, on the other hand, is the interest rate when
compounding more often than once a year is taken into consideration. Another way to

think of the effective interest rate is as the equivalent nominal interest rate that would
yield the same amount as compounding after 1 year.
In Example 1, $4,000 compounded quarterly at 6% per annum resulted in
$4,245.45 at the end of the year. Subtracting off the principal, we have $4,245.45 $4,000 = $245.45. Calculations reveal that $245.45 is 6.14% of $4,000
($245.45/$4,000 = 0.0613625). So, it would take a basic interest rate of 6.14% to
equal 6% compounded quarterly.
We examined the effects that frequent compounding has on interest rates in
Example 2 and in Table 1, but it was somewhat disguised. Another example is
warranted.
Example 5:
Suppose a principal of $10,000 is compounded (a) annually, (b) quarterly, (c)
monthly, (d) weekly, (e) daily, and (f) continuously at a per annum interest rate of 5%.
Write out the corresponding effective interest rates.
Solution:
The following table shows the nominal and effective interest rates. The values were
computed using formula (2) and formula (5).
Table 2

A basic interest rate of 5.095% would be needed to match 5% compounded


quarterly. A basic interest rate of 5.116% would be needed to equal 5% compounded
monthly, and so forth. The more often we compound, the higher the basic interest rate
needs to be in order to make the two quantities equal.