Chapter 2: Compound interest 1

Chapter 2: Compound interest.

Learning Objectives:

1. Understand the concept of compound interest and its significance in financial

applications, such as investments and loan repayments.

2. Learn the formula for calculating compound interest, including the variables involved
such as principal amount, annual interest rate, compounding frequency, and time
period.

3. Comprehend the derivation of the compound interest formula, including its

adaptation for continuous compounding and discrete compounding periods per
year.

4. Gain knowledge of the Rule of 72 and its application in estimating the time required
for an investment to double when compounded annually.

5. Understand the progression of compound interest across consecutive years and its
implications for financial decision-making.
 Chapter 2: Compound interest 2

The concept of Compound Interest.

Compound interest, denoted as C.I., refers to the interest computed on both the principal
amount and the previously accrued interest. It proves to be highly beneficial for various
financial endeavors, such as investments and loan repayments, earning its alternative
designation as "interest on interest."

Widely applied in the realms of banking, finance, and beyond, compound interest serves
multiple purposes, including but not limited to:

1. Contributing to the growth of a country's population.

2. Determining the value of an investment over a specific duration.

3. Uncovering inflated costs and the depreciated value of any given item.

4. Anticipating the growth trajectory of an institution or a nation.

The formula for calculating compound interest (C.I) is expressed as the difference between
the total amount and the principal:

C.I = Amount - Principal

Formula for Compound Interest.

The calculation of Compound Interest involves determining the total amount accrued over a
specified time period, considering the rate of interest and the initial principal. For an initial
principal of P, an annual interest rate of r, a time period of t years, and a compounding
frequency of n times per annum, the formula for computing CI is expressed as follows:

–P
nt
r
CI =P(1+ )
100

In the given context,

 P denotes the principal amount,

 Chapter 2: Compound interest 3

 r represents the rate of interest,

 n indicates the number of times interest is compounded per year,
 and t stands for the time period in years.

Expressing the formula for compound interest, we can state:

Compound Interest = A - P

In this context,

 A stand for the total amount of money after the compounding term, and
 P represents the initial principal amount.

-P
nt
r
Compound Interest = P(1+ )
n

Compound Interest can be computed yearly, half-yearly, quarterly, monthly, daily, etc. as
per the requirement.

Computing Compound Interest.

Compound interest refers to the interest accrued on both the initial principal amount and the
accumulated interest. At each interval, the interest earned is added to the original principal,
leading to a continuous increase in the principal.

Follow these steps to determine compound interest:

1. Record the given principal, rate, and time period.

n
r
2. Utilize the formula A=P(1+ ) to calculate the amount.
100

3. Find the compound interest using the formula CI = Amount – Principal.

At regular intervals, the interest accumulated is combined with the existing principal, and
the interest for the new principal is then computed. The new principal is the sum of the
initial principal and the accumulated interest.
 Chapter 2: Compound interest 4

Derivation of Compound Interest Formula.

The compound interest formula is a potent financial tool employed to compute the accrued
or paid interest on an initial principal amount, encompassing both the initial principal and
the interest accumulated in preceding periods. The formula for compound interest is
articulated as:

t
r
A=P(1+ )
n

Where:

 A is the future value of the investment or loan, inclusive of interest.

 P is the principal amount (initial investment or loan amount).
 r is the annual interest rate (expressed as a decimal).
 n is the number of times interest is compounded per year.
 t is the duration for which the money is invested or borrowed, in years.

Now, let’s systematically derive this formula:

1. Simple Interest Formula:

Simple interest, calculated solely on the principal amount, can be represented by the

A=P+ P .r . t
formula:

2. Compound Interest Formula with Continuous Compounding:

When interest is compounded continuously (infinitely many times per year), the compound
interest formula is derived utilizing the formula for continuous compounding:

rt
A=P. e
 Chapter 2: Compound interest 5

Where e is Euler’s number (approximately 2.71828), P is the principal amount, r is the

annual interest rate, and t is the time in years.

3. Comprehensive Compound Interest Formula:

To establish the comprehensive compound interest formula, let's contemplate compounding

interest n times per year.

When P is compounded n times annually at an annual interest rate r, the interest r is

divided by n and applied n times each year. Consequently, after t years, the formula takes
the form:
nt
r
A=P(1+ )
n

r
 signifies the interest rate per compounding period.
n
 nt represents the total number of compounding periods over t years.

This formula elucidates the growth of the initial principal amount over time when interest is
compounded at regular intervals. As n approaches infinity (i.e., continuous compounding),
the formula converges toward the continuous compounding formula A=P. e rt

nt
r
In sum, the compound interest formula A=P(1+ ) emerges from the continuous
n
compounding formula adapted for discrete compounding periods per year. It facilitates the
calculation of the future value of an investment or loan, accounting for compounded interest
at regular intervals.

Half-Yearly Compound Interest Formula.

Consider a principal investment denoted as P with an annual interest rate of R% that is
compounded half-yearly for a duration of t years.

Due to the half-yearly compounding, the principal undergoes a change at the conclusion of
every 6 months. The interest earned during this interval is added to the principal, resulting
in the establishment of a new principal. Subsequently, the final amount is calculated based
on this new principal.

Key considerations:
 Chapter 2: Compound interest 6

 The interest rate is R% per annum compounded half-yearly.

R
 Consequently, the interest rate per compounding period becomes % to reflect the
2
half-yearly compounding.
 The total time duration is t years, which equates to 2t half-years.

The formula for the final amount (A) is expressed as:

2t
R
A=P(1+ )
200

CI = A – P

Quarterly Compound Interest Formula.

Consider a principal investment denoted as P with an annual interest rate of R% that
undergoes quarterly compounding for a duration of t years.

Due to the quarterly compounding, the principal undergoes a change at the culmination of
every 3 months. The interest earned during this interval is added to the principal,
transforming it into the new principal. Subsequently, the final amount is determined based
on this revised principal.

Key points:

 The interest rate is R% per annum compounded quarterly.

R
 This translates to a quarterly interest rate of % to account for the quarterly
4
compounding.
 The total time duration is t years, equivalent to 4t quarters.
 The formula for the final amount (A) is expressed as:

4t
R
A=P(1+ )
400

CI = A – P
 Chapter 2: Compound interest 7

Formula for Periodic Compounding Rate.

The overall amount, encompassing both the principal (P) and the compounded interest (CI),
is determined by the formula:

nt
r
A=P[1+ ]
n

where:

 P represents the principal amount,

 A signifies the final amount,
 r denotes the annual interest rate,
 n stands for the number of times interest is compounded, and
 t represents the time duration in years.

Consequently, the compound interest (CI) is derived as:

CI = A – P

The Rule of 72
The Rule of 72 is a formula utilized to estimate the number of years it takes for an
investment to double when compounded annually. For instance, if an amount is invested at
an annual interest rate of r%, it will take approximately 72/r years for the investment to
double.

This calculation proves beneficial not only for determining the doubling time of an
investment but also for evaluating the diminished value of an asset. It provides an estimate
of how many years it will take for the value of an asset to halve if depreciated annually.

Formula for the Rule of 72:

72
N= r
 Chapter 2: Compound interest 8

where:

 N is the approximate number of years for the money to double,

 r is the annual compounding rate.

Example:

Let's consider an example where Emile has invested 1,000,000 rupees in a debt fund with
an 8% return. Using the Rule of 72 formula:

72
N= = 9 years.
8

Therefore, it will take approximately 9 years for Emile's investment to double.

Compound Interest Across Consecutive Years.

When considering the same principal sum and a consistent interest rate, the compound
interest (C.I.) for a given year consistently surpasses the C.I. of the preceding year. (For
instance, the C.I. for the 3rd year exceeds that of the 2nd year.) The discrepancy between
the C.I. for any two successive years equates to the interest earned in one year on the C.I.
of the preceding year.

1
C.I. of 3rd year − C.I. of 2nd year = C.I. of 2nd year × r × 100

Similarly, the disparity between the amounts for any two consecutive years corresponds to
the interest earned in one year on the amount of the preceding year.

1
Amount of 3rd year−Amount of 2nd year = Amount of 2nd year × r × 100

Key Findings:

When the principal sum and interest rate remain constant:

C.I. for nth year = C.I. for (n – 1) th year + Interest for one year on C.I. for (n – 1) th year

Exercises.
Exercise 1.
 Chapter 2: Compound interest 9

In the year 2000, a town had a population of 10,000 residents. The population experiences
a yearly decline of 10%. What will be the total population in 2005?

Solution:

The town's population diminishes by 10% annually, resulting in a new population each year.
The population for the upcoming year is computed based on the current year's population.
The formula for decrease is A=P(1−R /100)n

Hence, the population at the end of 5 years is calculated as follows:

5
10
1000(1− ) ≈ 5904
100

Exercise 2.

Calculate the compound interest for a principal amount of Rs 6000, an annual interest rate
of 10%, and a duration of 2 years.

Solution:

Interest for the first year is determined as (6000 × 10 × 1)/100 = 600. The amount at the
end of the first year becomes 6000 + 600 = 6600.

Interest for the second year is calculated as (6600 × 10 × 1) / 100 = 660. The amount at the
end of the second year is 6600 + 660 = 7260.

The compound interest is then found by subtracting the principal from the final amount:
7260 – 6000 = 1260.

Exercise 3.

Determine the compound interest on an amount of Rs 8000 over a two-year period with an
annual interest rate of 2%.

Solution:

Given principal (P) = Rs 8000, interest rate (r) = 2%, and time (n) = 2 years. Applying the
compound interest formula:
 Chapter 2: Compound interest 10

n
R
A=P(1+ )
100
n2
2
A=8000(1+ )
100

A = 8323

Compound interest is calculated as A−P, thus:

Compound interest = 8323 − 8000 = Rs 323

Exercise 4.

Calculate the compound interest for 2 years at a 5% per annum rate on a principal amount
that yields Rs. 400 as simple interest in 2 years at the same 5% per annum rate.

Solution:

Given: Simple Interest (SI) = Rs. 400

Rate (R) = 5%

Time (T) = 2 years

Using the formula for simple interest:

P ×T × R
SI =
100

SI ×100 400 ×100

P= = = Rs.4000
T ×R 2 ×5

Now, for compound interest:

Rate of Compound Interest = 5%

Time = 2 years

Using the compound interest formula:

R 5
A=P(1+ ) = 4000 (1+ ) = 4410
100 100

Compound Interest = A - P = 4410 - 4000 = Rs. 410