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Compound Interest

# Compound Interest

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08/10/2012

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# 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 principal on hand at the beginning of the period has been multiplied by (1 + r). • • • • • . To discount A means to find its present value P.  If money can be invested at the rate r per period. Interest due at end of let period is Pr. or the determination of the amount A when we know the principal P. Hence. Then. By the method of Example 1 find the compound amount after 1 year if \$100 is invested at the rate 6%. The discount on A is (A P). converted quarterly. the compound amount after k periods is P(l + r)*. Find the compound amount after 9 years and 3 months on a principal P = \$3000. We shall call P the present value of A. 4. Find the annual rate of growth of principal under the rate . The accumulation problem is solved by equation A = P ( 1 + r )* EXERCISES: 1. if money earns 4%. due at the end of k periods.  Let the interest rate per conversion period be r. the interest rate. we shall prove that: A = P ( 1 + r )*  The method of Example 1 applies in establishing equation 15.The Compound Interest Formula. expressed as a decimal. . by the end of k periods. 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. To accumulate P. Therefore. Interest due at end of 2d period is P(1 + r)r. because if P is invested now it will grow to the value A by the end of k periods. if the rate is 6%. 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.04. means to find the compound amount A resulting from the investment of P. due at the end of 4 years and 6 months. (b) The discount problem. payable quarterly. What was the compound amount after 6 months? At what rate per year does principal increase in this case? 2.  The fundamental problems under compound interest are the following : (a) The accumulation problem. Original principal invested is P. Let P be the original principal and let A be the compound amount to which P accumulates by the end of k conversion periods. compounded quarterly. converted semi-annually. 3. the sums P and A are equally desirable. New principal at end of 1st period is P + Pr = P(1 + r) . Find the present value of \$5000. the original principal P has been multiplied k successive times by (1 + r) or by (1 + r)*. and the time for which P is invested.

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