Cherry Mhay M.

Aguilar
GEMMW01X – BSCE211C

Compound Interest
Compound interest is interest computed on the original principal as well as on
any accumulated interest.

Example:
You deposit $2000 in a savings account at Hometown Bank, which has a rate of
6%.
a. Find the amount, A, of money in the account after three years subject to
interest compounded once a year.
b. Find the interest.
Solution
a. The amount deposited, or principal, P, is $2000. The rate, r, is 6%, or 0.06.
The time of the deposit, t, is three years. The amount in the account after
three years is

𝐴 = 𝑃(1 + 𝑟 )𝑡 =2000(1+0.062) ³=2000(1.062) ³≈2382.03.

Rounded to the nearest cent, the amount in the savings account after three
years is $2382.03.

b. Because the amount in the account is $2382.03 and the original principal is
$2000, the interest is $2382.03-$2000, or $382.03.

Compound Interest Paid More Than Once a Year

The period of time between two interest payments is called the compounding
period. When compound interest is paid once per year, the compounding period
is one year. We say that the interest is compounded annually.
compounded semiannually-If compound interest is paid twice per year.
compounded quarterly- When compound interest is paid four times per year.

The following formula is used to calculate the amount in an account subject to

compound interest with n compounding periods per year:

EXAMPLE:
You deposit $7500 in a savings account that has a rate of 6%. The interest is
compounded monthly.
a. How much money will you have after five years?
b. Find the interest after five years.
SOLUTION:
a. The amount deposited, or principal, P, is $7500. The rate, r, is 6%, or 0.06.
Because interest is compounded monthly, there are 12 compounding periods
per year, so n=12. The time of the deposit, t, is five years. The amount in the
account after five years is
𝑟 𝑛𝑡 0.06 12∗5
𝐴 = 𝑃 (1 + ) = 7500 (1 + ) = 7500(1.005)60 = 10,116.38
𝑛 12
Rounded to the nearest cent, you will have $10,116.38 after five years.
b. Because the amount in the account is $10,116.38 and the original principal
is $7500, the interest after five years is $10,116.38-$7500, or $2616.38.
Continuous Compounding
Some banks use continuous compounding, where the compounding periods
increase infinitely (compounding interest every trillionth of a second, every
quadrillionth of a second, etc.). As n, the number of compounding periods in a
1
year, increases without bound, the expression (1 + 𝑛)𝑛 approaches the irrational
number e: e≈2.71828.

EXAMPLE:
You decide to invest $8000 for six years and you have a choice between two
accounts. The first pays 7% per year, compounded monthly. The second pays
6.85% per year, compounded continuously. Which is the better investment?
SOLUTION:
The better investment is the one with the greater balance in the account after six
years. Let’s begin with the account with monthly compounding. We use the
compound interest formula with P=8000, r=7, =0.07, n=12 (monthly compounding
means 12 compounding periods per year), and t=6.

The balance in this account after six years would be $12,160.84.

For the second investment option, we use the formula for continuous
compounding with P=8000, r=6.85, =0.0685, and t=6.

The balance in this account after six years would be $12,066.60, slightly less than
the previous amount. Thus, the better investment is the 7% monthly compounding
option.
Planning for the Future with Compound Interest

Remember to round the principal up to the nearest cent when computing present
value so there will be enough money to meet future goals.
EXAMPLE:
How much money should be deposited today in an account that earns 6%
compounded monthly so that it will accumulate to $20,000 in five years?
SOLUTION:
The amount we need today, or the present value, is determined by the present
value formula. Because the interest is compounded monthly, n=12.Furthermore, A
(the future value) =$20,000, r (the rate) =6,=0.06,and t (time in years) =5.

To make sure there will be enough money, we round the principal up to

$14,827.45. Approximately $14,827.45 should be invested today in order to
accumulate to $20,000 in five years.

EFFECTIVE ANNUAL YIELD

The effective annual yield, or the effective rate, is the simple interest rate that
produces the same amount of money in an account at the end of one year as
when the account is subject to compound interest at a stated rate.
EXAMPLE:
You deposit $4000 in an account that pays 8% interest compounded monthly.
a. Find the future value after one year.
b. Use the future value formula for simple interest to determine the effective
annual yield.

SOLUTION:
a. We use the compound interest formula to find the account’s future value
after one year.
Rounded to the nearest cent, the future value after one year is $4332.00.
b. The effective annual yield, or effective rate, is a simple interest
rate. We use the future value formula for simple interest to determine the
simple interest rate that produces a future value of $4332 for a $4000
deposit after one year.

The effective annual yield, or effective rate, is 8.3%. This means that money
invested at 8.3% simple interest earns the same amount in one year as money
invested at 8% interest compounded monthly.
(The stated 8% rate is called the nominal rate. The 8.3% rate is the effective rate
and is a simple interest rate.)

EXAMPLE:
A passbook savings account has a nominal rate of 5%. The interest is compounded
daily. Find the account’s effective annual yield. (Assume 360 days in a year.)
SOLUTION:
The rate, r, is 5%, or 0.05. Because interest is compounded daily and we assume
360 days in a year, n=360. The account’s effective annual yield is
The effective annual yield is 5.13%. Thus, money invested at 5.13% simple
interest earns the same amount of interest in one year as money invested at 5%
interest, the nominal rate, compounded daily.
Concept and Vocabulary
Fill in each blank so that the resulting statement is true.
1. Compound interest is interest computed on the original PRINCIPAL
AMOUNT as well as on any accumulated INTEREST
𝑟 𝑛𝑡
2. The formula 𝐴 = 𝑃 (1 + 𝑛 ) gives the amount of money, A, in an account
after t years at rate r subject to compound interest paid n times per
year.
3. If interest is compounded once a year, the formula in Exercise 2 becomes
A=P(1+r)t
4. If compound interest is paid twice per year, the compounding period is 6
months and the interest is compounded SEMIANNUALLY
5. If compound interest is paid four times per year, the compounding period
is 3 months and the interest is compounded QUARTERLY
6. When the number of compounding periods in a year increases without
bound, this is known as CONTINUOUS compounding.
𝐴
7. In the formula 𝑃 = 𝑟 𝑛𝑡
, the variable p represents the amount that
(1+ )
𝑛
needs to be invested now in order to have A dollars accumulated in t
years in an account that pays rate __r__ compounded __n__ times per year.
8. If you are selecting the best investment from two or more investments, the
best choice is the account with the greatest EFFECTIVE ANNUAL YIELD
which is the SIMPLE interest rate that produces the same amount of
money at the end of one year as when the account is subject to compound
interest at a stated rate.
In Exercises 9–12, determine whether each statement is true or false. If the
statement is false, make the necessary change(s) to produce a true statement.
9. Formulas for compound interest show that a dollar invested today is worth
more than a dollar invested in the future. TRUE
10. Formulas for compound interest show that if you make the decision to
postpone certain purchases and save the money instead, small amounts of
money can be turned into substantial sums over a period of years. TRUE
11. At a given annual interest rate, your money grows faster as the
compounding period becomes shorter. TRUE
12. According to the Rule of 72 (see the Blitzer Bonus on page 524), an
investment with an effective annual yield of 12% can double in six years.
TRUE