COMPOUND INTEREST

Definition of Compound Interest.

 If, at stated intervals during the term of an investment, the interest due is added
to the principal and thereafter earns interest, the sum by which the original
principal has increased by the end of the term of the investment is called
compound interest.

 At the end of the term, the total amount due, which consists of the original
principal plus the compound interest, is called the compound amount.

 We speak of interest being compounded, or payable, or converted into principal.

The time between successive conversions of interest into principal is called the
conversion period.

 In a compound interest transaction we must know:

o the conversion period and
o the rate at which interest is earned during a conversion period.

 Thus, if the rate is 6%, compounded quarterly, the conversion period is 3 months
and interest is earned at the rate 6% per year during each period, or at the rate
1.5% per conversion period (or 1.5% per quarter, that is 6% per annum divided
by into 4 quarters).

Example 1. Find the compound amount after 1 year if $100 is invested at the rate 8%,
compounded quarterly.

Solution.

The rate per conversion period is 2%. Original principal is $100.

• At the end of the first 3 months or first quarter, a $2.000 interest is due, the
new principal is $102.000
• At end of the second quarter, a $2.040 interest is due. New principal is
$104.040
• At end of the third quarter, a $2.081 interest is due. The new principal is
$106.121
• At end of 1 yr, $2.122 interest is due. New principal is $108.243.

The compound interest earned in 1 year is $8.243

The rate of increase of principal per year is 8.243%.
The Compound Interest Formula.

 Let the interest rate per conversion period be r, expressed as a decimal. Let P be
the original principal and let A be the compound amount to which P accumulates
by the end of k conversion periods. Then, we shall prove that:

A = P ( 1 + r )*

 The method of Example 1 applies in establishing equation 15.

• Original principal invested is P.

• Interest due at end of let period is Pr.
• New principal at end of 1st period is P + Pr = P(1 + r) .
• Interest due at end of 2d period is P(1 + r)r.
• New principal at end of 2d period is P(1 + r) + P(1 + r)r = P(1 + r) 2
.

 By the end of each period, the principal on hand at the beginning of the period
has been multiplied by (1 + r). Hence, by the end of k periods, the original
principal P has been multiplied k successive times by (1 + r) or by (1 + r)*.
Therefore, the compound amount after k periods is P(l + r)*.

 If money can be invested at the rate r per period, the sums P and A are equally
desirable, because if P is invested now it will grow to the value A by the end of k
periods. We shall call P the present value of A, due at the end of k periods.

 The fundamental problems under compound interest are the following :

(a) The accumulation problem, or the determination of the amount A

when we know the principal P, the interest rate, and the time for which P
is invested. To accumulate P, means to find the compound amount A
resulting from the investment of P.

(b) The discount problem, or the determination of the present value P

of a known amount A, when we know the interest rate and the date on
which A is due. To discount A means to find its present value P. The
discount on A is (A P). The accumulation problem is solved by equation A
= P ( 1 + r )*

EXERCISES:

1. By the method of Example 1 find the compound amount after 1 year if $100 is
invested at the rate 6%, payable quarterly. What was the compound amount after
6 months? At what rate per year does principal increase in this case?

2. Find the annual rate of growth of principal under the rate .04, converted quarterly.

3. Find the compound amount after 9 years and 3 months on a principal P = $3000,
if the rate is 6%, compounded quarterly.

4. Find the present value of $5000, due at the end of 4 years and 6 months, if
money earns 4%, converted semi-annually.