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.

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

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
Future amount,
The factor (1+i)n is called single-payment compound-amount factor and is denoted by (F/P,i,n).
Present amount,
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,
Interest rate per compounding period,
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 rm→0. 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,