Compound Interest

If the interest due is added to the principal at the end of

each interest period and thereafter earns interest, the
interest is said to be compounded. The sum of the
original principal and total interest is called the
compound amount or accumulated value. The difference
between the accumulated value and the original
principal is called compound interest. The interest
period, the time between two successive interest
computations, is so called the conversion period.
 Interest may be converted into principal annually (1), semiannually (2),
quarterly (4), monthly (12), weekly (52), daily (365) or continuously. The
number of times interest is converted in one year, or compounded per year, is
called the frequency of conversion. The rate interest is usually stated as an
annual interest rate, referred to as the nominal rate of interest. The phrase
“interest at 12% or “money worth 12% means 12% compounded annually;
otherwise, the frequency of conversion is indicated, e.g., 16% compounded
semiannually, 10% compounded daily. When compounding daily, most U.S.
banks use a 365-day year.
P = original principal, or the present value of S, or the discounted value of S
S = compound amount of P, the accumulated value of P
n = total number of interest ( or conversion) periods involved
m = number of interest periods per year, or the frequency of compounding

jm = nominal (yearly) interest rate which is compounded (payable, convertible) m

times per year in some textbooks the nominal interest rate jm is denoted by i(m)
or r)
i = interest rate per interest period
The accumulated value S of principal at rate jm for t years is
S = P(1+ i)n = P (1+ jm/m)mt = P [(1 + jm /m)m]t
Examples.
1. Find the compound interest on $1000 at (a) j12 = 6% for 5 years, (b) j12 = 15%
for 30 years.
2. A person deposited $1000 into a retirement savings plan on February 4, 1978.
How much money will be in the plan on February 4, 1998, at 11.4% compounded
daily, assuming ( a ) approximate time ( 1 year = 360 days)? ( b ) exact time (1
year =365 days)?
3. Fifteen hundred dollars is invested for 18 months at a nominal rate of 13%. Find
the accumulated value if interest is compounded (a) monthly, (b) continuously.
4. Two thousand dollars are invested for 10 years at j12 =10% for the first 3 years,
at j4 = 8% for the next 4 years, and at j12 = 9% for the last 3 years. Find the
accumulated value after 10 years.
EQUIVALENT RATES
For a given nominal rate of interest, the accumulated
value S increases with increasing frequency of conversion.
Two nominal rates with different frequencies of conversion
are said to be equivalent if they yield the same accumulated
value at the end of one year (hence, at the end of any
number of years).
For a given nominal rate of interest jm (compounded m
times per year), we define the annual effective interest rate
to be that rate j which, if compounded annually, will yield the
same amount of interest per year.
SOLVED PROBLEMS
1. Find the rate (a) j12 equivalent to j1 = 10.08%, (b) j2 equivalent to j4 = 12%, (c) j4
equivalent to j = 9%, (d) per month equivalent to 5% per half-year.
2. Find the annual effective interest rate j corresponding to (a) 15% compounded
continuously; (b) a nominal rate jm.
3. What simple interest rate r is equivalent to j365 = 12% if money is invested for 3
years?
4. A savings and loan association offers guaranteed investment certificates
paying interest at j12 = 11¼%, j2 = 11½%, and j1 = 11¾%. Which option is the
best?
DISCOUNTED VALUE
In business transactions it is frequently necessary to determine what
principal P now will accumulate at a given compound interest rate i to a
specified amount S at a specified date (n interest periods from now).
P = S (1+ i) -n
Examples
1. How much would have to be deposited today in an investment fund paying j12=
10.4% to have $2000 in 3 years’ time?
2. Find the present value of $8000 due in 5 years at 7% compounded (a)
quarterly, (b) daily, (c) continuously.
3. A note for $2500 dated August 1, 1993, is due with compound interest at j12
=15¼% four years after date. On November 1, 1994, the holder of the note has it
discounted by a lender who charges j4 =13½%. Find the proceeds and the
compound discount.
4. A person can buy a lot for $30 000 now; or for $12 000 now, $12 000 in 2
years, and $12 000 in 5 years. Which option is better, if money can be invested at
(a) j12 = 12%? (b) j12 = 8% for the 3 years and j4 = 6% for the next 2 years?
EXERCISES
Accumulated Value
1. Find the accumulated value of $100 for 5 years at
16%compounded (a) annually, (b) semiannually, (c)
quarterly, (d) monthly, (e) weekly, (f) daily, (g)
continuously .
2. Find the compound interest earned on
(a) $500 for 2 years 2 months at 11 ¼ % compounded
monthly
(b)$1000 for 6 years at 9% compounded semiannually
(c)$850 for 3 years at 8.2% compounded continuously
(d) $10 000 for 1 year at 10.7% compounded daily,
(e) $220 for 18 months at 18 ½ compounded quarterly
Equivalent Rates
3. Find
(a) j4 equivalent to j2=8%, (b) j2 equivalent to j4 = 8%
(c)j4 equivalent to j12 = 8.05%,(d) j2 equivalent to j52 = 11%
(d) j12 equivalent to j∞ = 15%
4. Find the annual effective rate to
(a) 16% compounded quarterly, (b) 18% compounded
monthly
(c) 9 ¼ % compounded monthly, (d) 12% compounded
continuously
5. Find the nominal rate jm equivalent to the annual
effective rate j, if (a) j = 6%, m = 2, (b) j = 9%, m = 4,
(c) 10% , m = 12, (d) j = 17%, m = 365
Discounted Value
6. Find the present value
(a) $100 000 due in 25 years, if money is worth j12 = 12%,
(b) $2500 due in 10 years, if money is worth j2 = 9.6%,
(c)$800 due in 3 years, if money is worth 12% compounded daily
(d) $3000 with interest at j12 = 16 ½ % due in 5 years, if money is
worth 15% effective.
7. An obligation of $2000 is due December 31, 2000. What is value
of this obligation on June 30, 1996, at j4 = 13 ¼%.
8. On her 20th birthday a young woman receives $1000 as a result of
a deposit her parents made on the day she was born. How large was
that deposit. If it earned interest at j2 = 6%, (b) j4 = 12%?
ACCUMULATED AND DISCOUNTED VALUES FOR FRACTIONAL
INTEREST PERIODS
Formulas were developed on the assumption that n is an integer.
Theoretically, they may be used whether n is an integer or a fraction. When we
calculate the accumulated value or the discounted value using a fractional part
of an interest conversion period, we are employing the exact or theoretical
method of accumulating or discounting.
In practice, the exact method is rarely used. Instead, we used compound
interest for the number of complete interest periods and simple interest (at the
stated nominal yearly rate) for the fractional part of the interest period. This
method is called the approximate or practical method of accumulating or
discounting; it yields slightly larger values than does the exact method.
SOLVED PROBLEMS

1. Find the accumulated value of $ 1000 over 5 years 7 months at j2 =13½%,

using the exact method.
2. Find the discounted value of $2800 due in 3 years 7 months if money is
worth 10% effective and the exact method is used.
3. Solved Problem 1 using the approximate method.
4. Solved Problem 2 using the approximate method.
5. A promissory note for $ 2000 dated April 5, 1994, is due on October 1, 1998,
with interest at j1 = 12%. On June 7, 1995, the holder of the note has it
discounted at a bank which charges j4 =14%. Find the proceeds and the
compound discount.
Finding the Rate
When P, S and n are given , we may solve for the
unknown interest rate i, either directly or by by
use of logarithms.
Examples
Finding the Time
Equation of Values
EXERCISES