COMPOUND INTEREST METHOD
Compound interest – interest on top of interest
- Both the principal and the interest earn interest.
Nomenclature:
𝑟 = 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑛 = 𝑝𝑒𝑟𝑖𝑜𝑑 𝑖𝑛 𝑦𝑒𝑎𝑟 𝑃 = 𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑎𝑚𝑜𝑢𝑛𝑡
𝐹 = 𝑎𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑒𝑑 𝑎𝑚𝑜𝑢𝑛𝑡 = 𝑃 + 𝐼
Principal at the beginning of Accumulated amount at the
Period Interest during the period (I)
the period (P) end of the period (F)
1 𝑃 𝑃𝑟 𝑃 + 𝑃𝑟 = 𝑃(1 + 𝑟)
2 𝑃(1 + 𝑟) 𝑃(1 + 𝑟)𝑟 𝑃(1 + 𝑟) + 𝑃(1 + 𝑟)𝑟
𝑃(1 + 𝑟)(1 + 𝑟) = 𝑃(1 + 𝑟)2
3 𝑃(1 + 𝑟)2 𝑃(1 + 𝑟)2 𝑟 𝑃(1 + 𝑟)2 + 𝑃(1 + 𝑟)2 𝑟
𝑃(1 + 𝑟)2 (1 + 𝑟) = 𝑃(1 + 𝑟)3
4 𝑃(1 + 𝑟)3 𝑃(1 + 𝑟)3 𝑟 𝑃(1 + 𝑟)3 + 𝑃(1 + 𝑟)3 𝑟
𝑃(1 + 𝑟)3 (1 + 𝑟) = 𝑃(1 + 𝑟)4
n 𝑃(1 + 𝑟)𝑛−1 𝑃(1 + 𝑟)𝑛−1 𝑟 𝑃(1 + 𝑟)𝑛
Principal at the beginning of Accumulated amount at the
Period Interest during the period (I)
the period (P) end of the period (F)
1 100 100(0.05) = 5 105
2 105 105(0.05) = 5.25 105 + 5.25 = 110.25
3 110.25 110.25(0.05) = 5.51 110.25 + 5.51 = 115.76
4 115.76 115.76(0.05) = 5.79 115.76 + 5.79 = 121.55
𝐹4 = 100(1 + 0.05)4 = 121.55
𝐶𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑 (𝑚) = 𝑖𝑡 𝑖𝑠 𝑡ℎ𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝑡ℎ𝑎𝑡 𝑜𝑐𝑐𝑢𝑟𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
𝑚 = 1 (𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝑎𝑛𝑛𝑢𝑎𝑙𝑙𝑦) 𝑚 = 2 (𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝑠𝑒𝑚𝑖 − 𝑎𝑛𝑛𝑢𝑎𝑙𝑙𝑦)
𝑚 = 4 (𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝑞𝑢𝑎𝑟𝑡𝑒𝑟𝑙𝑦) 𝑚 = 6 (𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝑏𝑖 − 𝑚𝑜𝑛𝑡ℎ𝑙𝑦)
𝑚 = 12 (𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝑚𝑜𝑛𝑡ℎ𝑙𝑦) 𝑚 = 365 (𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝑑𝑎𝑖𝑙𝑦)
𝑚 = ∞ (𝑐𝑜𝑛𝑡𝑖𝑛𝑢𝑜𝑢𝑠 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔)
𝑇𝑜𝑡𝑎𝑙 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 (𝑁) = 𝑚 𝑥 𝑛
𝑟
𝑖 = 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑝𝑒𝑟 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑 =
𝑚
𝒓 (𝒎)(𝒏)
𝑭 = 𝑷(𝟏 + 𝒊)𝑵 = 𝑷 (𝟏 + )
𝒎
Sample Problems:
1. Engr. Pangan borrowed money from Engr. Gadia amounting to P 100,000.00 at a rate of 8%
compounded quarterly. He promised to pay the amount due at the end of a year. How much should he
pay at the end of the period?
Given:
𝑃 = 𝑃 100,000.00 𝑟 = 8% 𝑛 = 1 𝑚 = 4
𝑟 8%
𝑁 = 4(1) = 4 𝑖= = = 2%
𝑚 4
Solution:
𝐹 = 𝑃 100,000.00(1 + 0.02)4 = 𝑃 108,243.22
𝐼 𝑃 8,243.22
𝑒= = = 0.0824 𝑜𝑟 8.24%
𝑃 𝑃 100,000.00
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑖𝑠 𝑡ℎ𝑒 𝑎𝑐𝑡𝑢𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
𝐹 − 𝑃 𝑃(1 + 𝑖)𝑚 − 𝑃 𝑃((1 + 𝑖)𝑚 − 1) 𝑟 𝑚
𝑒= = = = (1 + 𝑖)𝑚 − 1 = (1 + ) − 1
𝑃 𝑃 𝑃 𝑚
0.08 4
𝑒 = (1 + ) − 1 = 𝟎. 𝟎𝟖𝟐𝟒 𝒐𝒓 𝟖. 𝟐𝟒%
4
2. What is the least number of years needed to triple a certain amount of money at 5% compounded
annually?
Given:
𝑃 = 𝑃 𝐹 = 3𝑃 𝑟 = 5% 𝑚 = 1
𝑟 5%
𝑖= = = 5% 𝑁 = 𝑚𝑛 = 1(𝑛) = 𝑛
𝑚 1
Solution:
𝐹 = 𝑃(1 + 𝑖)𝑁
3𝑃 = 𝑃(1 + 0.05)𝑛
3 = 1.05𝑛
ln 3 = ln 1.05𝑛 = 𝑛 ln 1.05
𝑛 = (ln 3)/(ln 1.05) = 𝟐𝟐. 𝟓𝟐 𝒚𝒆𝒂𝒓𝒔
3. Anan Bautista expects to receive P 50,000.00 in 6 years. How much is that money worth now
considering interest at 6% compounded quarterly?
Given:
𝐹 = 𝑃 50,000.00 𝑛 = 6 𝑟 = 6% 𝑚 = 4 𝑃 =?
Solution:
𝑟 𝑚𝑛
𝐹 = 𝑃(1 + 𝑖)𝑁 = 𝑃 (1 + )
𝑚
0.06 (4)(6) 𝑃 50,000.00
𝑃 50,000.00 = 𝑃 (1 + ) 𝑃= = 𝑷 𝟑𝟒, 𝟗𝟕𝟕. 𝟐𝟎
4 0.06 24
(1 + 4 )
4. Determine the effective rate of interest corresponding to 18% compounded daily.
Given:
𝑟 = 18% 𝑚 = 365 𝑒 =?
Solution:
𝑟 𝑚 0.18 365
𝑒 = (1 + ) − 1 = (1 + ) − 1 = 𝟎. 𝟏𝟗𝟕𝟐 𝒐𝒓 𝟏𝟗. 𝟕𝟐%
𝑚 365
5. Determine the value of P 20,000.00 in 5 years at 5% compounded quarterly.
Given:
𝑃 = 𝑃 20,000.00 𝑛 = 5 𝑟 = 5% 𝑚 = 4 𝐹 =?
Solution:
(4)(5)
𝑟 𝑚𝑛 0.05
𝐹 = 𝑃 (1 + ) = 𝑃 20,000.00 (1 + ) = 𝑷 𝟐𝟓, 𝟔𝟒𝟎. 𝟕𝟓
𝑚 4
6. If P 5,000.00 shall accumulate for 10 years at 8% compounded quarterly. Find the compounded interest
at the end of 10 years.
Given:
𝑃 = 𝑃 5,000.00 𝑛 = 10 𝑟 = 8% 𝑚 = 4 𝐼 =?
Solution:
𝑟 𝑚𝑛 𝑟 𝑚𝑛 0.08 (4)(10)
𝐼 = 𝐹 − 𝑃 = 𝑃 (1 + ) − 𝑃 = 𝑃 [(1 + ) − 1] = 𝑃 5,000.00 [(1 + ) − 1]
𝑚 𝑚 4
= 𝑷 𝟔, 𝟎𝟒𝟎. 𝟐𝟎
