Compound Interest

Definition
Simple Interest vs. Compound Interest
Formula
Sample Problems
Unit 2: Compound Interest

Objectives:
At the end of this unit, you must be able to
1. determine the compound amount and compound
interest of an investment;
2. compute the present value and compound
discount;
3. differentiate effective rate from nominal rate;
4. compare interest yield using the same interest rate
but different conversion periods;
Overview
Compound interest is an interest computed
every conversion period whose principal amount
includes the specified interest earned every end
of the conversion date.
The computation of compound amount involves the
computation of compound interest. When interest
is compounded more than once a year, then the
interest rate is nominal but if compounded once
a year, then the rate is effective.
Introduction
Examples of compound interest:

car loans - interest is compounded monthly.

mortgage loans - rates are semiannually

compounded.

In any long-term financial planning, interest is

always compounded
Compound Interest
The simple interest method discussed in
Unit 1 is restricted primarily to loans and
investments having terms of less than one
year.

The compound interest method is

employed in virtually all instances where the
term exceeds one year.
Compound Interest
In the compound interest method, interest is
periodically calculated and converted to principal.
“Converting interest to principal” means
that the interest is added to the principal and is
thereafter treated as principal. Consequently,
interest earned in one period will itself earn
interest in all subsequent periods.
The time interval between successive interest
conversion dates is called the compounding
period.
Compound Interest

Definition
• is interest that is paid on both the principal
or the amount invested and on any interest
previously credited.
Simple Interest vs. Compound Interest

Simple interest always calculates interest based

on the original amount.
So P1,000 at 4% per year for 2 years
 Year 1: P1,000 * 4%  P40 in interest for
the first year.
 Year 2: P1,000 * 4%  P40 in interest for
the second year.

So after 2 years you would have

P1,000 * 4% *2  P80 interest
For a total of P1,080
Simple Interest vs. Compound Interest
Compound interest - always calculate interest
based on “latest amount”
–Year 1: P1,000 at 4%/yr for 1 year is P40
– Year 2: P1,040* 4% =P41.60

so now after 2 years you have P1,081.60

Total Interest
$82.00
P82

$81.00
P81

P80
$80.00

P79
$79.00
Simple Interest Compound Interest
SimpleInterest CompoundInterest
Difference
 SIMPLE INTEREST
 PRINCIPAL IS CONSTANT

 COMPOUND INTEREST
 PRINCIPAL INCREASES REGULARLY
 INTEREST ALSO EARNS INTEREST
Simple Interest vs. Compound
Interest

Suppose you have P96 000 for 3 years. Should you

deposit the money in a bank that pays 2% interest
compounded annually or you better off lending the
money to your uncle who has agreed to pay you 2%
simple interest?
Compounding Frequency
In many circumstances, interest is
compounded more frequently than once per
year. The number of
compoundings/conversions per year is called
the compounding frequency.
Interest Rate
A compound interest rate is normally
quoted with two components:
● a number for the annual interest rate
(called the nominal interest rate)
● words stating the compounding frequency
(annually, semi-annually, monthly, . . . )

We use the term periodic interest rate for

the interest rate per compounding period
Periodic Interest Rate

nominal interest rate

Periodic Interest Rate =
number of compoundings per year

r
i
m
Examples
Calculating the periodic interest rate i
Calculate the periodic interest rate
corresponding to:
a. 10.5% compounded annually
b.9.75% compounded semiannually
c. 9.0% compounded quarterly
d.9.5% compounded monthly
Examples
Calculating compounding frequency
For a nominal interest rate of 8.4%, what is
the compounding frequency if the periodic
interest rate is:
a. 4.2% b. 8.4% c. 2.1% d. 0.7%

Calculating nominal interest rate r

Determine the nominal rate of interest if:
a. The periodic rate is 1.75% per quarter.
b. The periodic rate is 0.83% per month.
Finding Compound Amount and
Compound Interest
When an amount P is invested at interest rate r
compounded m periods a year for t number of
years, the compound amount (accumulated
amount F can be computed using the formula:

tm
 r
F  P 1  
 m
To simplify this formula, we introduce new variables.
Finding Compound Amount and
Compound Interest
Consider the following variables:
n  total number of compoundings
m  number of compoundings per year

r
n  mt i
m
n
F  P1 i
Finding Compound Amount and
Compound Interest
To compute for the compound interest I the following
formula can be used:

I=F–P

or

I = P[(1 + i)n – 1]
Sample Problems
1. An amount of P7 500 was invested for one year in
an account that pays 3% compounded quarterly.
Find the amount in the account at the end of the
term.
2. Miguel wants to know how large his P25 000
deposit will become at a monthly compound
interest rate of 8% at the end of 5 years.
3. Find the amount and interest on P14,700 for 5
years and 6 months at 12% compounded
semiannually.
Other Formulas
Present Value P

F
P= or P = F(1 + i)-n
(1  i ) n

Interest Rate, r Time, t

F
 F  log
 P
r=  n
P
1( m)(100%) t= m log1  i  
 
Sample Problems
4. Assume that Catherine needs P192 000 ten years
from now. How much should Catherine deposit
today in an account that pays 6% interest,
compounded semi-annually to reach
the required amount?

5. How long does it take to double P10 000 at a

compound rate of 12% per year?
6. If one invests P2 000 today and has accumulated
P2 676.45 after exactly five years, what rate of
annual compound interest was earned?
Sample Problems
7. A car is purchased on installment. The buyer makes
a Php230,000 down payment and owes a balance of
P450,000 to be paid in 4 years. Find the car’s cash
value if money is worth 6% compounded quarterly?
8.
Exercise
1. How long will it take Php5,000 to accumulate to
Php13,000 if invested at 8%, compounded
semiannually?
2. If Ban San Miguel pays Php6,000 now instead
Php11,000 at the end of 7 years and 9 months, at what
rate, compounded quarterly, does money earn interest?
3. If Meding Abrenica borrows Php8,000 and promises to
pay back Php11,500 after 3 years and 10 months, at
what rate, compounded monthly, is interest computed?
4. How long will it take for Php3,000 to accumulate to
Php8,500 if interest is computed at a rate of 9%,
compounded monthly?
5. How long will it take money to double itself at 8%,
compounded quarterly?
Exercise
1. Accumulate Php40,000 at 12% compounded semi-
annually for 4 years and 10 months.
2. If Php305,000 accumulates to Php866,000 in 5
years. What is the interest rate compounded
monthly?
3. For a sum of Php9,500 to triple itself in 6 years and
6 months, what must be the rate of interest
compounded semi-annually?
4. How long will it take for Php3,000 to accumulate to
Php8,500 if interest is computed at a rate of 9%,
compounded monthly?
5. How long will it take money to double itself at 8%,
compounded quarterly?
EQUIVALENT RATES
 Two rates, with different conversion
periods, are equivalent if they produce
equal compound amounts on a given
principal at the end of a specified time.
Example
 At the end of one year, accumulate
Php10,000 at 4% compounded quarterly
and 4.06% compounded annually.
 Given:
 P = 10,000
 r1 = 4% or 0.04
 m1= 4
 r2 = 4.06% or 0.0406
 m2 = 1
 Required: F1 and F2
 Formulas: F1 = P(1+i)n and F2 = P(1+i)n
 Computation:
 F1 = 10000[1 + (0.04/4)]4 = 10,406
 F2 = 10000[1 + (0.0406/1)]1 = 10,406
 Conclusion:
 Therefore, 4% compounded quarterly is
equivalent to 4.06% compounded
annually.
Formula

 m1

  r1  m2
r2  1    1( m2 )100
 m1  
 
Examples
 Find the rate compounded quarterly that is
equivalent to
a) 8.5% compounded semiannually
b) 6% compounded monthly
NOMINAL AND EFFECTIVE
RATES
 Nominal rate is the rate quoted when
interest is compounded more than once a
year.
 The interest actually earned in one year is
called effective rate.
 When interest is compounded annually,
the effective rate is equal to the nominal
rate, but when it is compounded more
than once a year, the effective rate is
higher than the nominal.
FORMULA
Nominal Rate r
 1

r   1  e  m  1  m   100 
 
Effective Rate e

 r 
m 
e   1    1  100 
 m 
 
EXAMPLES
1. What nominal rate compounded monthly,
will yield the effective rate 4%?
 Answer: 3.93%

2. If interest is compounded quarterly find

the nominal rate if the effective rate is 9%.
 Answer: 8.71%
EXAMPLES
3. Find the effective rate corresponding to
the rate 5% compounded quarterly.
 Answer: 5.09%

4. When interest is compounded monthly,

find the effective rate corresponding to the
nominal rate 3%.
 Answer: 3.04%
EXAMPLES
5. Which yields a higher interest, 10%
compounded quarterly or 12%
compounded semi-annually?
EXCERCISE
1. When interest is compounded monthly,
find the nominal rate if the effective rate is:
a. 6 ½%
b. 5/12%
c. 1 ¾%
2. Find the effective rate corresponding to the
rate 13% compounded:
a. Semi-annually
b. Quarterly
c. Monthly
Answers
 Nominal rate
 6.31%
 0.42%
 1.74%
 Effective rate
 13.42%
 13.64%
 13.80%
COMPARISON OF RATES
 Comparing two rates of interests is the same
as comparing their effective rates. The
following formulas will be used:
 r1 
m1

e1  1    1(100)

 m1  
 r2 
m2

e2  1    1(100)
 m2  
 Which yields a higher interest, 10%
compounded quarterly or 12%
compounded semi-annually?
 Which is better, to invest money at 8%
compounded semiannually or at 8 ½%
annually?
 Other things being equal, would an
investor prefer an interest rate of 8.25%
compounded monthly or 9% compounded
semiannually for a two-year investment?
SIMPLE INTEREST RATE
 To determine the simple interest rate equivalent
to compound interest rate we apply this formula:
 1  i  n  1 
rs    100
 t 
• where:
• rs =unknown simple interest
• i = periodic rate
• n = the total number of conversion periods for the whole term
• t = the term or time of the investment
EXAMPLE
 WHAT SIMPLE INTEREST RATE IS
EQUIVALENT TO 5 ½% COMPOUNDED
SEMI-ANNUALLY, IF MONEY IS INVESTED
FOR 5 ½ YEARS?
 ANSWER: 6.32%
 Find the simple interest rate equivalent to:
 7%, m = 12 for 7 years
 6%, m = 4 for 6 years
 5%, m = 2 for 5 ½ years
 Answers:
 9%
 7.16%
 5.67%
COMPOUND INTEREST RATE
 To determine the compound interest rate equivalent to
simple interest rate we apply this formula:

rc   n 1  rst   1 m100

• where:
• rc =unknown compound interest rate
• rs = given simple interest rate
• m = no. of conversion period per year
• n = the total number of conversion periods for the whole term
• t = the term or time of the investment
EXAMPLE
 MS. INES PLANS TO INVEST PHP100,000
AT 12 ½% SIMPLE INTEREST FOR THREE
YEARS. AT WHAT RATE COMPOUND
INTEREST m=4 COULD SHE JUST AS
WELL INVEST FOR THE SAME PERIOD OF
TIME?
 ANSWER:10.76%
 What rate compounded quarterly is
equivalent to simple interest rate:
 7 ¼% for 7 years
 11 ½% for 5 ½ years
 13 ½% for 8 years and 6 months
 Answers:
 5.91%
 9.01%
 9.09%