Time Value of Money Compound Interest

Calculation of Compound Interest

Introduction
The need to calculate compounded interest is a common denominator in many
situations, both from an investment point of view, and from a loan re-payment point
of view.
The formula for calculating compound interest as an integral part of calculating the
future value of an investment is applicable to situations where payments of equal
size are made into some fund, or account. Further, the payments are made at
regular intervals for a pre-determined period of time, and with a constant, or fixed,
interest rate. Examples of such situations are mortgage loans, car loans, etc., and
regular deposits into a retirement account through payroll deductions.
In reality, however, the interest rate frequently varies, requiring frequent
recalculation of the expected future value of the investment or loan.

Definition of Compound Interest

Interest calculated on the original sum of money lent or borrowed and on all the
unpaid interest already earned or owed.
Compound interest is contrasted to simple interest, in which returns are not earned
on interest received.

Variables
The following variables apply:
K = Invested, or deposited, amount every period (assumed to be year in this
document) for a pre-determined period of time. All amounts are expressed in
US$.
n = The number of periods (the amount K is invested, or deposited, in each period).
i = The interest rate (assumed to be an APR in this document).
FV = The future value of the investment (the value at the end of the pre-
determined period of time; see the variable K )
R = A factor defined as
 i 
R = 1 + 
 100 

www.dabbleklix.com 1 01/03/08
Time Value of Money Compound Interest

Investment Scenarios
There are two investment (or re-payment) scenarios to be considered:

Scenario 1: The payments, or deposits, are made at the beginning of each period,
such as month, year, or other period.
Scenario 2: The payments, or deposits, are made at the end of each period,
such as month, year, or other period.

Scenario 1:
We will begin with analyzing a specific situation, and then generalize the findings.
Assumptions, see Table 1:

Table 1

VARIABLE VALUE

Invested, or deposited amount each period 1000

Number of periods, years 4

Interest rate (APR), percent 5

The investment scenario is shown in Fig. 1 below:

Table 2

Year 1 Year 2 Year 3 Year 4 Future Value (FV)

K K ⋅ R4
K K ⋅ R3
K K ⋅ R2
K K ⋅ R1

Calculation of the Future Value

The total future value pertinent to this scenario is obtained by inserting the values in
Table 1 into each of the equations in the right hand column in Table 2.

www.dabbleklix.com 2 01/03/08
Time Value of Money Compound Interest

Table 3

Investment Period Future Value Formula Future Value (FV)

1 1000 ⋅1.054 1215.51

2 1000 ⋅1.053 1157.63

3 1000 ⋅1.052 1102.50

4 1000 ⋅1.05 1050

Total Future Value 4525.64

Derivation of Compound Interest Formula

The future value resulting from four periods of deposits is
FV = K ⋅ R1 + K ⋅ R 2 + K ⋅ R 3 + K ⋅ R 4 (1)
Multiplying the equation 1 by the factor
−R
results in
( − R ) ⋅ FV = ( − R ) ⋅ ( K ⋅ R1 + K ⋅ R 2 + K ⋅ R3 + K ⋅ R 4 ) (2)

( − R ) ⋅ FV = R ⋅ ( − K ⋅ R1 − K ⋅ R 2 − K ⋅ R3 − K ⋅ R 4 ) (3)

( − R ) ⋅ FV = − K ⋅ R 2 − K ⋅ R3 − K ⋅ R 4 − K ⋅ R5 (4)

Adding the equations 1 and 4 results in

FV = K ⋅ R1 + K ⋅ R 2 + K ⋅ R 3 + K ⋅ R 4 (1)
( − R ) ⋅ FV = − K ⋅ R 2
− K ⋅R − K ⋅R − K ⋅R
3 4 5
(4)

FV − R ⋅ FV = K ⋅ R − K ⋅ R 5 (5)

(
FV ⋅ (1 − R ) = K ⋅ R ⋅ 1 − R 4 ) (6)

 1 − R4 
FV = K ⋅ R ⋅   (7)
 1− R 
Multiplying both sides of the equation 7 by the factor
 −1 
 
 −1 

www.dabbleklix.com 3 01/03/08
Time Value of Money Compound Interest

 −1   −1   1 − R4 
  ⋅ FV =   ⋅ K ⋅ R ⋅   (8)
 −1   −1   1− R 
 R4 −1 
FV = K ⋅ R ⋅   (9)
 R −1 
Testing the equation 9 by applying the values in Table 1 results in
 1.054 − 1 
FV = 1000 ⋅1.05 ⋅   (10)
 1.05 − 1 
 0.21550625 
FV = 1050 ⋅   (11)
 0.05 
FV = 4525.63 (12)

Neglecting the rounding error in the 2nd decimal place, the equation 12 confirms the
result in Table 3.
Generalizing the equation 9 results in
 Rn −1 
FV = K ⋅ R ⋅   (13)
 R −1 

Scenario 2:
We will, again, begin with analyzing a specific situation, and then generalize the
findings.
Assumptions, see Table 4:

Table 4

VARIABLE VALUE

Invested, or deposited amount each period 1000

Number of periods, years 4

Interest rate (APR), percent

The investment scenario is shown in Table 5 below:

www.dabbleklix.com 4 01/03/08
Time Value of Money Compound Interest

Table 5

Year 1 Year 2 Year 3 Year 4 Future Value (FV)

K K ⋅ R3
K K ⋅ R2
K K ⋅ R1
K K ⋅ R0

Calculation of the Future Value

The total future value pertinent to this scenario is obtained by applying the values in
Table 4 into each of the equations in the right hand column in Table 6.
Table 4

Investment Period Future Value Formula Future Value (FV)

1 1000 ⋅1.053 1157.63

2 1000 ⋅1.052 1102.50

3 1000 ⋅1.051 1050

4 1000 ⋅1.050 1000

Total Future Value 4310.13

Derivation of the Compound Interest Formula

The future value resulting from four periods of deposits is
FV = K ⋅ R 0 + K ⋅ R1 + K ⋅ R 2 + K ⋅ R 3 (14)
Multiplying the equation 14 by the factor
−R
results in
( − R ) ⋅ FV = ( − R ) ⋅ ( K ⋅ R 0 + K ⋅ R1 + K ⋅ R 2 + K ⋅ R3 ) (15)

( − R ) ⋅ FV = R ⋅ ( − K ⋅ R 0 − K ⋅ R1 − K ⋅ R 2 − K ⋅ R3 ) (16)

( − R ) ⋅ FV = − K ⋅ R1 − K ⋅ R 2 − K ⋅ R3 − K ⋅ R 4 (17)

Adding the equations 14 and 17 results in

FV = K ⋅ R 0 + K ⋅ R1 + K ⋅ R 2 + K ⋅ R 3 (14)
( − R ) ⋅ FV = − K ⋅ R1 − K ⋅ R 2 − K ⋅ R3 − K ⋅ R 4 (17)

www.dabbleklix.com 5 01/03/08
Time Value of Money Compound Interest

FV − R ⋅ FV = K ⋅ R 0 − K ⋅ R 4 (18)

FV − R ⋅ FV = K − K ⋅ R 4 (19)

(
FV ⋅ (1 − R ) = K ⋅ 1 − R 4 ) (20)

 1 − R4 
FV = K ⋅   (21)
 1− R 
Multiplying both sides of the equation 21 by the factor
 −1 
 
 −1 
 −1   −1   1 − R4 
  ⋅ FV =   ⋅ K ⋅   (22)
 −1   −1   1− R 
 R4 −1 
FV = K ⋅   (23)
 R −1 
Testing the equation 23 by applying the values in Table 4 results in
 1.054 − 1 
FV = 1000 ⋅   (24)
 1.05 − 1 
 0.21550625 
FV = 1000 ⋅   (25)
 0.05 
FV = 4310.13 (26)

The equation 26 confirms the result in Table 6.

Generalizing the equation 24 results in
 Rn −1 
FV = K ⋅   (27)
 R −1 
Note that the difference between the equations 13 and 27 is the factor
R
on the right hand side in the equation 13. This is the tell-tale sign as to whether the
deposits are made at the beginning or at the end of the periods that constitute the
total investment, or loan, period.
As usual, if the period is other than year, the exponent
n

www.dabbleklix.com 6 01/03/08
Time Value of Money Compound Interest

in the equation 27 must be modified accordingly as well as the value of

i
in the factor
 i 
1 + 
 100 
on page 1.
Refer to the documents Derivation of the Annuity Calculation Formula and
Future Value of a Single Investment.

www.dabbleklix.com 7 01/03/08