Compound Interest

In compound interest, the interest earned by the principal at the end of each interest period (compounding period) is added to the principal. The sum (principal + interest) will earn another interest in the next compounding period.
 

Consider $1000 invested in an account of 10% per year for 3 years. The figures below shows the contrast between simple interest and compound interest.
 

At 10% simple interest, the $1000 investment amounted to $1300 after 3 years. Only the principal earns interest which is $100 per year.
 

000-simple-interest.gif

 

At 10% compounded yearly, the $1000 initial investment amounted to $1331 after 3 years. The interest also earns an interest.
 

000-compound-interest.gif

 

Elements of Compound Interest
P = principal, present amount
F = future amount, compound amount
i = interest rate per compounding period
r = nominal annual interest rate
n = total number of compounding in t years
t = number of years
m = number of compounding per year

i=rm   and   n=mt

 

Future amount,

F=P(1+i)n   or   F=P(1+rm)mt

The factor   (1+i)n   is called single-payment compound-amount factor and is denoted by   (F/P,i,n).
 

Present amount,

P=F(1+i)n

The factor   1(1+i)n   is called single-payment present-worth factor and is denoted by   (P/F,i,n).
 

Number of compounding periods,

n=ln(F/P)ln(1+i)

 

Interest rate per compounding period,

i=nFP1

 

Values of   i   and   n
In most problems, the number of years   t   and the number of compounding periods per year   m   are given. The example below shows the value of   i   and   n.

Example
Number of years,   t=5 years
Nominal rate,   r=18%

  • Compounded annually (m=1)

    n=1(5)=5

    i=0.18/1=0.18

  • Compounded semi-annually (m=2)

    n=2(5)=10

    i=0.18/2=0.09

  • Compounded quarterly (m=4)

    n=4(5)=20

    i=0.18/4=0.045

  • Compounded semi-quarterly (m=8)

    n=8(5)=40

    i=0.18/4=0.0225

  • Compounded monthly (m=12)

    n=12(5)=60

    i=0.18/12=0.015

  • Compounded bi-monthly (m=6)

    n=6(5)=30

    i=0.18/6=0.03

  • Compounded daily (m=360)

    n=360(5)=1800

    i=0.18/360=0.0005

 

Continuous Compounding (m → )
In continuous compounding, the number of interest periods per year approaches infinity. From the equation
F=(1+rm)mt
 

when   m,   mt=,   and   rm0.   Hence,
F=Plim
 

Let   x = \dfrac{r}{m}.   When   m \to \infty,   x \to 0,   and   m = \dfrac{r}{x}.

\displaystyle F = P \lim_{x \to 0}(1 + x)^{\frac{r}{x}t}

\displaystyle F = P \lim_{x \to 0}(1 + x)^{\frac{1}{x}rt}
 

From Calculus,   \displaystyle \lim_{x \to \infty}(1 + x)^{1/x} = e,   thus,

F = Pe^{rt}