4.
2 COMPOUND INTEREST
Maturity value is the amount payable to an investor at the end of a debt
instrument's holding period (maturity date). For most bonds, the maturity
value is the face amount of the bond.
a.) Let say you have invested a sum of $10,000 in a Bank for 5 years and a bank is
offering you 10% simple interest and 7.5% compound interest per year on this
investment. You want to calculate the maturity value of this investment.
V = P(1+RT)
= 10,000(1+(0.1*5)) For Simple Interest
= $15000
V = P(1+R)t
= 10,000(1+0.075)5 For Compound Interest
= $14356.29
Compound interest, or 'interest on interest', is calculated with the compound
interest formula. Multiply the principal amount by one plus the annual interest
rate to the power of the number of compound periods to get a combined figure
for principal and compound interest. Subtract the principal if you want just the
compound interest.
The above assumes interest is compounded once per period (yearly). When
incorporating multiple compounds per period (monthly compounding or quarterly
compounding, etc), the formula changes. It looks like this:
How to use the compound interest formula
To use the compound interest formula you will need figures for principal amount,
annual interest rate, time factor and the number of compound periods. Once you
have those, you can go through the process of calculating compound interest.
Where:
A = the future value of the investment/loan, including interest
P = the principal investment amount (the initial deposit or loan amount)
r = the annual interest rate (decimal)
n = the number of times that interest is compounded per unit t
t = the time the money is invested or borrowed for
You may have seen some examples giving a formula of A = P ( 1+r )t . This
simplified formula assumes that interest is compounded once per period, rather
than multiple times per period.
Let's look some examples:
1. If an amount of $5,000 is deposited into a savings account at an annual interest
rate of 5%, compounded monthly, the value of the investment after 10 years can
be calculated as follows...
P = 5000.
r = 5/100 = 0.05 (decimal).
n = 12.
t = 10.
If we plug those figures into the formula, we get the following:
A = 5000 (1 + 0.05 / 12)12*10 = 8235.05.
So, the investment balance after 10 years is $8,235.05.
2. A principal of $2000 is placed in a savings account at 3% per annum
compounded annually. How much is in the account after one year, two years and
three years?
When interest is compounded annually, total amount A after t years is given by:
A = P(1 + r) t, where P is the initial amount (principal), r is the rate and t is time in
years.
P = 2000 , r = 3% = 0.03
1 year: A = 2000(1 + 0.03) 1 = $2060
2 years: A = 2000(1 + 0.03) 2 = $2121.80
3 years: A = 2000(1 + 0.03) 3 = $2185.45
3. If $3000 is placed in an account at 5% and is compounded quarterly for 5 years.
How much is in the account at the end of 5 years?
Compounded n times a year and after t years, the total amount is given by:
A = P(1 + r/n) n t
Quarterly n = 4:
Hence, A = P(1 + r/4) 4 t = 3000(1 + 0.05/4) 4 × 5 = $3846.11
4. What principal you have to deposit in a 4.5% saving account compounded
monthly in order to have a total of $10,000 after 8 years?
P initial balance to find and final balance A known and equal to $10,000.
P= ?
r = 4.5/100 = 0.045 (decimal)
n = 12
t=8
Now we plug those figures in the formula:
A
P=
¿¿
A = P(1 + 0.045 / 12) 12 × 8 = 10,000
10,000
P=
¿¿
= $6981.46
Word Problems:
1. If you deposit $4000 into an account paying 6% annual interest
compounded quarterly, how much money will be in the account after 5 years?
2. If you deposit $6500 into an account paying 8% annual interest
compounded monthly, how much money will be in the account after 7 years?
3. If you deposit $5000 into an account paying 6% annual interest
compounded monthly, how long until there is $8000 in the account?
4. How much money would you need to deposit today at 9% annual interest
compounded monthly to have $12000 in the account after 6 years?
5. What principal will amount to S2000 if invested at 4% interest compounded
semiannually for 5 years?
6. What principal will amount to S3500 if invested at 4% interest compounded
quarterly for 5 years?
7. What principal will amount to S1750 if invested at 3% interest compounded
quarterly for 5 years?
8. A thousand dollars is left in a credit union drawing 7% compounded monthly.
What is the balance at the end of 10 years?
9. A thousand dollars is left in a bank savings account drawing 7% interest,
compounded quarterly for 10 years. What is the balance at the end of that time?
10. An 8.5% account earns continuous interest. If S2500 is deposited for 5 years,
what is the total accumulated?
