LESSON 6

COMPOUND INTEREST

At the end of the lesson, students are able to;

1. Know how to solve compound interest
2. Distinguish nominal rate from effective rate
3. Solve problems on compounding interest; equation of values; and continuous
compounding

Compound Interest

In calculations of compound interest, the interest for an interest period is

calculated on the principal rate plus total amount of interest accumulated in previous
period.
Compound interest means “ interest on top of interest” .

F = P ( 1 + i)n (6.1 )

Where i interest rate period = nominal rate ( j) / frequency of conversion (m) = j/m
n ( no. of conversion = time (t) x frequency of conversion (m) = tm

Compound Interest ( Borrower’s Viewpoint)

Interest Principal at Interest earned Amount at end

Period Beginning of During Period of Period
Period

1 P Pi P + Pi = P ( 1 + i )

2 P(1+i) P ( 1 + i )i P ( 1 + I ) + P ( 1 + i)i
= P (1 + i)2

3 P ( 1 + i)2 P ( 1+ i)2 i P ( 1 + i)2 + P ( 1 + i)2 i

= P( 1 + i)3

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 The quantity ( 1 + i)n is commonly called “ single payment compound amount
factor” and is designated by the functional symbol : ( F /P, i%, n )

F = P ( F /P, i%, n ) ( 6.2)

P = F ( 1 + i)-n (6.3)

The quantity ( 1 + i)-n is called “single payment present worth factor” and is
designated by the functional factor : ( P /F, i%, n )

P = F (P /F , i%, n ) (6.4)

Finding the time , t

Formula : log F /P
n = -----------------
log ( 1 + i)

t = n/m

Example: Rosario makes an investment worth P15,000 in a savings bank paying 14%
compounded monthly. If she withdraws all her investments and the interest which
amounts to P19,450, for how long did she invest her money?

Solution: Given: P = P15,000 F = P19,450 j = 14% m = 12

i = j/m = 0.14 /12 = 0.012

Log F/P log 19,450 / 15,000

n = --------------- = --------------------------
log( 1+i) log ( 1 + 0.012)

log 1.296 0.112605

n = --------------- = --------------- = 21.74

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 log 1.012 0.00518

n 21.74
t = ------- = ----------- = 1.81 years
m 12

Rate of Interest

a. Nominal rate of Interest (j )

The nominal rate of interest specifies the rate of interest and a number of interest
periods in one year.
(F) 1/n
i = ---------- - 1
P
j = im (6.5)

where: i = rate of interest

j = nominal interest rate
m = number of compounding periods per year or frequency of
conversion

1. If the nominal rate of interest is 10% compounded quarterly, then i = j / m

= 10% / 4 = 2.5%, rate of interest per period.

Solution : j = im ; i = j/m = 0.10/4 = 0.025 = 2.5%

2. At what rate compounded quarterly will P14,000 become P16,500 for 3 years
?
Given: P = P14,000 ; F = P16,500 m = 4; t = 3 years

(F) 1/n ( 16,500 ) 1/12

i = ---------- - 1 = --------------- - 1 = 0.013786084
P 14,000

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 j = im = ( 0.013786084) ( 4) = 0.05514 = 5.514%
Frequency of Conversion
Per year / annum m = 1
Semi – annually m = 2
Quarterly m = 4
Monthly m = 12

b. Effective rate of Interest (w)

Effective rate of interest is the actual or exact rate of interest on the principal
during one year. It is the interest rate compounded annually .

If Php100 , is invested at a nominal rate of 15% compounded quarterly, after one

year will become

Php100 ( 1 + .15/4 )4 = Php100 ( 1.1586) = Php 115,865

Effective rate (w) = F1 – 1 = ( 1 + i)m – 1 (6.6)

Finding the Effective Rate equivalent to a given Nominal Rate

w = ( 1 + i )m – 1

Finding Nominal Rate equivalent to given Effective Rate

i = ( 1 + w ) 1/m - 1

j = im

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Finding simple interest rate equivalent to a given nominal rate

(1+i)n -1
r = ------------------ where i = j/m
t

Finding Nominal Rate equivalent to Simple interest rate

i = ( 1 + rt )1/n – 1 where i = j/m

Example:

1. Find the nominal rate which if converted quarterly could be used instead of 12%
compounded monthly. What is the corresponding effective rate?

Solution : Given ; j = 12% ; m = 12

Let j = nominal rate

For two or more nominal rates to be equivalent, their corresponding effective rate
must be equal.

Nominal Rate Effective rate

j % compounded quarterly ( 1 + j /4 )4 - 1

12% compounded monthly ( 1 + 12 /12)12 - 1

Equating both sides :

( 1 + j /4 )4 - 1 = ( 1 + 12 /12)12 - 1

( 1 + j /4 )4 - 1 = ( 1.01)12 - 1

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 1 + j /4 = ( 1.01)3

1 + j /4 = 1.0303

j / 4 = 1.0303 – 1

j / 4 = 0.0303

j = (0.03030) ( 4)

j = 0.1212 = 12.12% compounded quarterly

2. Find the amount at the end of 2 years and 7 months of Php1,000 is invested at
8% compounded quarterly using simple interest for anytime less than a year
interest period.

Solution:
Compounded quarterly = m = 4

For compound interest : i = j /m = 8% / 4 = 2%

n = t m = 2 years x 4 = 8

For simple interest : i = 8% ,

n = 7 months /12months = 0.583

F1 = P ( 1 + i)n = Php1,000 ( 1 + 0.02)8 = Php1,171.66

F2 = F1 ( 1 + n i) = Php1,171.66 ( 1 + (.583)(.08)
= Php1,226.31

3. A Php 2,000 loan was originally made at 8% simple interest for 4 years. At the
end of this period the loan was extended for 3 years without the interest being

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paid, but the new interest was made 10% compounded semi-annually. How
much should the borrower pay at the end of 7 years?

Solution :

F4 :
P = 2,000 , n = 4 years I = 8%

F4 = P ( 1 + n i) = 2,000 ( 1 + (4) (0.08)

= 2,000 ( 1.32) = Php = 2,640

F7 :
P = 2,640 , n = 7 years m = 2 semi-annually
r = 10% , I = r/m = 10% / 2 = 0.05

F7 = P ( 1 + i)n = 2640 ( 1 + 0.05)7 = 2640 ( 1.4071)

= Php 3,714.75

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Lesson 6: Exercises 1

1.How long will it take for Php 600 to accumulate to Php 2,500 at 12%
compounded semi-annually?

P = 600 j = 12% i = 0.12 / 2 ; i = 0.06

F = 2,500 m=2

log F /P log 2,500 /600 log 4.167

n= ; n= ; n=
log(1+i) log (1+0.06) log (1.06)

0.61982
n= ; n=24.48913
0.02531

n 24.48913
t= ; t= ; t=12.24457
m 2

2.When will Php 760,000 grow to Php 870,240 if it is invested at 6.75%

compounded semi-annually?
P = 760,000 j = 6.75% i = 0.0675 / 2 ; i = 0.03375
F = 870,240 m=2

870,240
log F /P log log 1.14505
n= ; 760,000 ; n=
log(1+i) n= log(1.03375)
log (1+0.03375)

0.05883
n= ; n=4.07906
0.01442

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 n 4.07906
t= ; t= ; t=2.03953
m 2
3.Determine the effective rate equivalent to
a. 14% converted annually
1
a=(1+0.14 )−1
1 ; a=0.14 ; 14 %

b. 21% compounded semi-annually

1
(
b= 1+0.21 2 −1 ) ; b=0.45826 ; 45.8 %

c. 12% compounded quarterly

1
c=( 1+ 0.12 )−1
4 ; c=0.58857 ;58.9 %

4.Find the nominal rate converted monthly equivalent to each of the given
effective rates.
a. 15%
j 12 j 12
15 %=(1+ ) −1 ; 0.0125=(1+ ) −1 ; a = 0.14 ; 14%
12 12

b. 18.5%
j 12 j 12
18.5 %=(1+ ) −1 ; 0.185=(1+ ) −1 ; b = 0.17 ; 17%
12 12

5.Find the simple interest rate which I s equivalent to 22%, converted

monthly for 8 years.

6.Find the nominal rate that is converted monthly which is equivalent to

15% simple interest for 12 years.

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Equation of values

An equation of values is obtained by setting the sum of obligations equal to the

sum of the values on the same date of another set of obligations.
Example :
1. A man bought a lot worth Php1,000,000 if paid in cash. On the instalment basis ,
he paid a down payment of Php200,000; Php 300,000 a the end of 1 year;
400,000 at the end of 3 years and a final payment at the end of 5 years. What
was the final payment if interest was 20%?
Solution:
Let Q = final payment
Given: Original amount = Php1,000,000
Down payment = Php 200,000
Amount balance = Php800,000
Using today as the focal date, the equation value is :
800,000 = 300,000 ( P /F, 20%,1) + 400,000 ( P /F, 20%, 3) +
Q ( P /F, 20%, 5)

P = F ( 1 + i)-n

800,000 = 300,000 ( 1 + 0.20) -1 + 400,000 ( 1 + 0.20 ) -3 + Q ( 1 +.20) -5

800,000 = 300,000 ( 1.20) -1 + 400,000 ( 1.20 ) -3 + Q ( 1.20) -5

800,000 = 300,000 ( 0.8333) + 400,000( 0.5787) + Q( 0.4019)

800,000 = 249,990 + 231,480 + Q( 0.4019)

800,000 = 481,470 + Q(0.4019)

800,000 - 481,470 = Q ( .4019)

Q = Php792, 560.34

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Continuous Compounding and Discrete Payments

In discrete compounding, the interest is compounded at the end of each finite –

length period such as a month, a quarter, or a year.

In continuous compounding it is assumed that each payment occurs once per

year, but the compounding is continuous throughout the year.

F = P ( 1 + j /m )mn ( 4.9)

Where:
j = nominal rate
j/m = rate of interest per year
m = number of interest periods per year
mn = number of interest periods in n year

let m / j = k ; then m = jk, as m increases so must k

( 1 + j /m)m n = ( 1 + 1 /k ) jkn = [ ( 1 + 1 / k)k] rjn

The limit of ( 1 + j / m) k as k approaches infinite is e

[ ( 1 + 1 / k)k ] j n = e j n

Thus, F = Pe j t (4.10)

P = Fe –jt (4.11)

Examples:

1. Compare the accumulated amounts after 5 years of Php1,000 invested at the

rate of 10% per year compounded
a) Annually
b) Semi-annually
c) Quarterly
d) Monthly
e) Daily
f) Continuously

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Solution :

Given : P = 1,000 ; n = m t = (1)(5 years) r = 10%

Using the formula: F = P ( 1 + i)n

a) Annually : m = 1
F = 1,000( 1 + j /m)5 = 1,000 ( 1 + .10/ 1)5
= 1,000 ( 1 + .10)5 = 1,000( 1.10)5
= 1,000 ( 1.61051)
= Php 1,610.51
b) Semi-annually : m= 2 ; n = (2) (5) = 10

F = 1,000 ( 1 + .10 / 2)10 = 1,000 ( 1 + .05)10

= 1,000 ( 1.05) 10 = 1,000 ( 1.62889)

= Php 1,628.89

c) Quarterly ; m = 4 ; n = (5)(4) = 20

F = 1000 ( 1 + 0.10/4)20 = 1,000( 1+ 0.025)20

= 1,000 ( 1.025)20 = 1,000 ( 1.63862)

= Php 1,638.62

d) Monthly ; m = 12 ; n = (5) (12) = 60

F = 1,000 ( 1 + .10 / 12 ) 60 = 1,000 ( 1 + 0.0083333) 60

= 1,000 ( 1.0083333) 60 = 1,000( 1.64531)

= Php 1,645.31

e) Daily : m = 365 j = 0.10 n = ( 5) ( 365) = 1825

F = 1,000 ( 1 + 0.10 /365) 1825 = Php 1,648.61

f). Continuous ; j = .10; t = 5; e = 2.71828

F = P e jt = 1,000 ( e) .10 ( 5)

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 = Php 1.648.72

Exercises

1. Determine the present value of Php 45,000 due at the end of 6 years with 14%
interest compounded semi-annually.

2. Discount Php 8,000 at 16% compounded quarterly for 5 years.

3. Accumulate Php 7,000 for 2 years at 11% compounded monthly.

4. What is the compound amount if Mr. Clave deposited Php 55,000 in a bank which
pays 9% compounded quarterly for 5 years?

5. Accumulate Php10,500 for 6 years at 7% converted semi-annually.

6. Discount Php150,000 for 8 years at 9.5% converted quarterly for 7 years.

7.If Php 10,000 is deposited at 12% for 7 years, what will be the compound amount if
the interest is converted monthly.

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8. Jerry wants to have Php 120,000, six years from today. How much would he deposit
today in the bank paying 14% compounded quarterly.

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