Compound Interest

Chapter 3

Mathematics of Finance ƒ Unlike simple interest,

interest compound interest on an amount
accumulates at a faster rate than simple interest. The basic
idea is that after the first interest period, the amount of
interest is added to the principal amount and then the
interest is computed on this higher principal. The latest
Section 2
computed interest is then added to the increased principal
Compound
p and Continuous Compound
p Interest g
and then interest is calculated again. This pprocess is
completed over a certain number of compounding periods.
The result is a much faster growth of money than simple
interest would yield.

Example Solution

Suppose a principal of $1.00 was invested in an account ƒ Solution: Using the simple interest formula A = P (1 + rt)
paying
i 6% annuall interest
i t t compounded
d d monthly.
thl How
H we obtain:
0.06
much would be in the account after one year? ƒ amount after one month 1+ (1) = 1(1 + 0.005) = 1.005
12

P=1.00 ƒ after two months

ƒ after three months
1.005(1 +
0.06
12
) = 1.005(1.005) = 1.0052

r= 6% ⎛ 0.06 ⎞
1.0052 ⎜1 +
⎝ 12 ⎠
⎟ = 1.005 (1.005) = 1.005
2 3

F=? F=P(1+r)^t After 12 months, the amount is 1.00512 = 1.0616778.

= 1(1+0.06/12)^12 With simple interest, the amount after one year would be 1.06.

=1.061 The difference becomes more noticeable after several years.

3 4
 Graphical Illustration of General Formula
Compound Interest

Growth of 1.00
1 00 compounded monthly at 6% annual interest ƒ In the previous example,
example the amount to n
⎛ 0.06 ⎞
⎜1 + ⎟ = (1.005)
n
over a 15 year period (Arrow indicates an increase in value of which 1.00 will grow after n months
almost 2.5 times the original amount.) compounded monthly at 6% annual ⎝ 12 ⎠
interest is mt
⎛ r⎞
Growth of 1.00 compounded monthly at 6% annual interest
3 over a 15 year period
ƒ This formula can be generalized to A = P ⎜ 1 + ⎟
2.5
⎝ m⎠
2
where A is the future amount,
amount P is the principal,
principal r is the interest
1.5
rate as a decimal, m is the number of compounding periods in
1 one year, and t is the total number of years. To simplify the
A = P (1 + i )
formula, n r
0.5
i=
0
m
5 n = mt 6

Compound Interest General Formula Example

A = P (1 + i )
n
ƒ Find the amount to which $1500 will ggrow if compounded
p
quarterly at 6.75% interest for 10 years.
where i = r/m

F=P(1+r)^t
A = amount (future amount) at the end of n periods
P = principal (present value)
F=1500(1+0.0675/4)
r = annual nominal rate P= 1500
m = number of compounding periods per year ^10(4)
r=0.0675
i = rate per compounding period
F= 2929.50
t = total number of compounding periods
t=10
7 8
 Same Problem Using
Example
Simple Interest

ƒ Find the amount to which $1500 will grow if compounded Using the simple interest formula,
formula the amount to which $1500
quarterly at 6.75% interest for 10 years.
will grow at an interest of 6.75% for 10 years is given by
ƒ Solution: Use
A = P (1 + i )
n
A = P (1 + rt)
10(4)
⎛ 0.0675 ⎞ = 1500(1+0.0675(10)) = 2512.50
A = 1500 ⎜1 + ⎟
⎝ 4 ⎠
which is more than $400 less than the amount earned using
A = 2929.50 the compound interest formula.
ƒ Helpful hint: Be sure to do the arithmetic using the rules for
order of operations.

9 10

Changing the number of Changing the number of

compounding periods per year compounding periods per year

To what amount will $1500 grow if compounded daily at To what amount will $1500 grow if compounded daily at
6.75%
6 75% interest for 10 years? 6.75%
6 75% interest for 10 years?
10 ( 365 )
⎛ 0.0675 ⎞
A = 1500 ⎜ 1 + ⎟
P=1500 F=P(1+r)^t ⎝ 365 ⎠
i=0.0675 F= 1500(1 + Solution: = 2945.87
t=10 0.0675/365)^10(365) This is about $15.00 more than compounding $1500 quarterly
=2945.86 at 6.75% interest.
Since there are 365 days in year (leap years excluded), the
number of compounding periods is now 365. We divide the
annual rate of interest by 365. Notice, too, that the number of
compounding periods in 10 years is 10(365)= 3650.

11 12
 Effect of Increasing the
Computing the Inflation Rate
Number of Compounding Periods

ƒ Suppose a house that was worth

ƒ If the number of compounding periods per year is $$68,000
, in 1987 is worth
increased while the principal, annual rate of interest and $104,000 in 2004. Assuming a
constant rate of inflation from
total number of years remain the same, the future amount 1987 to 2004, what is the inflation
of money will increase slightly. rate?

13 14

Computing the Inflation Rate Computing the Inflation Rate

Solution (continued )
ƒ Suppose a house that was worth
$ ,
$68,000 in 1987 is worth ƒ Solution: ƒ If thee inflation
at o rate
ate
104,000 = 68,000 (1+ r ) →
17
$104,000 in 2004. Assuming a remains the same for the
constant rate of inflation from next 10 years, what will
1987 to 2004, what is the inflation 104,000
= (1+ r ) →
17 the house be worth in the
rate? year 2014?
68,000
1. Substitute in compound interest
104,000 P=104,000 F=P(1+r)^t
formula. 17 = (1+ r) → F=133518.9514
2. Divide both sides by 68,000 68,000 r=0.0253
3. Take the 17th root of both sides t=10
of equation 104,000 F=?
4. Subtract 1 from both sides to 17 −1 = r = 0.0253
solve for r. 68,000
15 16
 Computing the Inflation Rate Growth Time of an Investment
(continued )

ƒ If the inflation rate ƒ Solution: From 1987 to 2014 is ƒ How long g will it take for $$5,000
,
remains the same for the a period of 27 years. If the to grow to $15,000 if the money
next 10 years, what will inflation rate stays the same is invested at 8.5%
the house be worth in the over that period, r = 0.0253. compounded quarterly?
year 2014? Substituting into the compound
interest formula, we have F=P(1+r)^t
P=5000 15000=5000(1+0.085)^t
F=15000 3=1.085^t
r=0.085 t=13.466
A = 68, 000(1 + 0.0253) 27 = 133,501
log(3)=log(1.085)^t
log(3)=t(log1.085)
t=l0g(3)/log(1.085)
17 18

Growth Time of an Investment

Solution Continuous Compound Interest

ƒ How longg will it take for $$5,000

, ƒ Solution: Previously we indicated that increasing the number of
to grow to $15,000 if the money compounding periods while keeping the interest rate,
is invested at 8.5% principal, and time constant resulted in a somewhat higher
compounded quarterly? compounded amount. What would happen to the amount if
0.085 4t
1. Substitute values in the 15000 = 5000(1 + ) interest were compounded daily, or every minute, or every
compound interest formula. 4
3 = 1.021254t second?
2. divide both sides by 5,000
3. Take the natural logarithm of ln1 021254t
ln(3) = ln1.02125
both sides.
4. Use the exponent property of ln(3) = 4t*ln1.02125
logarithms ln(3)
5. Solve for t. t= = 13.0617
4 ln(1.02125)

19 20
 Answer to Continuous Compound Example of
Interest Question Continuously Compounded Interest

As the number m of compounding periods per year increases What amount will an account have after 10 years if $1,500
$1 500
without bound, the compounded amount approaches a limiting
is invested at an annual rate of 6.75% compounded
value. This value is given by the following formula:
continuously?
r mt
lim m→ ∞ P(1 + ) = Pert
m
A = Pert

Here A is the compounded amount.

21 22

Example of
Annual Percentage Yield
Continuously Compounded Interest
ƒ The simple interest rate that will produce the same amount as a
What amount will an account have after 10 years if $1,500
$1 500 given compound interest rate in 1 year is called the annual
is invested at an annual rate of 6.75% compounded percentage yield (APY). To find the APY, proceed as follows:
continuously?
Amount at simple interest APY after one year
Solution: Use the continuous compound interest formula = Amount at compound interest after one year
m
⎛ r⎞
A = Pert with P = 1500, r = 0.0675, and t = 10: P(1 + APY ) = P ⎜1 + ⎟ →
⎝ m⎠
A = 1500e(0.0675)(10)
(0 0675)(10) = $2,946.05
$2 946 05 m
⎛ r⎞
1 + APY = ⎜ 1 + ⎟ →
That is only 18 cents more than the amount you receive by ⎝ m ⎠
daily compounding. m This is also called
⎛ r⎞
APY = ⎜1 + ⎟ − 1 the effective rate.
⎝ m⎠
23 24
 Annual Percentage Yield Annual Percentage Yield
Example Example

What is the annual percentage yield for money that is What is the annual percentage yield for money that is
invested at invested at
6% compounded monthly? 6% compounded monthly?
m
⎛ r ⎞
APY = ⎜ 1 + ⎟ − 1
General formula: ⎝ m⎠
12
⎛ 0.06 ⎞
APY = ⎜1 + ⎟ − 1 = 0.06168
0 06168
Substitute values: ⎝ 12 ⎠

Effective rate is 0.06168 = 6.168

25 26

Computing the Annual Nominal Computing the Annual Nominal

Rate Given the APY Rate Given the APY
m
⎛ r⎞
ƒ What is the annual nominal rate ƒ What is the annual nominal rate APY = ⎜1 + ⎟ − 1
compounded monthly for a CD compoundedd d monthly
thl for
f a CD ⎝ m ⎠12
that has an annual percentage ⎛ r ⎞
that has an annual percentage
yield of 5.9%?
0.059 = ⎜ 1 + ⎟ − 1
yield of 5.9%? ⎝ 12 ⎠
ƒ 1. Use the general formula for 12
APY. ⎛ r ⎞
1.059 = ⎜1 + ⎟
ƒ 2. Substitute value of APY and 12 ⎝ 12 ⎠
for m (number of compounding
⎛ r ⎞
periods per year). 12
1.059 = ⎜ 1 + ⎟
ƒ 3. Add one to both sides ⎝ 12 ⎠
ƒ 4. Take the twelfth root of both r
sides of equation.
12
1.059 − 1 =
12
ƒ 5. Isolate r (subtract 1 and then
multiply both sides of equation by
12.
12 ( 12
)
1.059 − 1 = r

27
0.057 = r 28