COMPOUND INTEREST

UNIT BASIC CONCEPTS ON COMPOUND INTEREST

The simple interest method discussed is strictly mostly to loans and interest-earning
investments. The compound interest method is employed in virtually all instances where the
duration exceeds one year, and it is also used for some short-term loans and investment.

Compound interest is the procedure in which interest is periodically calculated and added to
the principal. The time interval between succeeding interest calculations is called the
conversion period (or compounding period or interval period). The interest earned during a
period is “converted” to principal at the end of the period because the principal and the
interest are combined and treated as the new principal for the succeeding period.

The Compound frequency (or conversion frequency) is the number of compoundings that
take place in a year. The common compounding or conversion periods encountered are listed
Compounding or conversion No. of compoundings or Compoundings or conversion per
frequency conversion per year periods

Annual 1 1 year

Semiannual 2 6 months

Quarterly 4 3 months

Bimonthly 6 2 months

Monthly 12 1 month

The nominal interest is the stated annual interest rate on which the compound
interest calculation is based. The periodic interest rate is the rate of the interest
earned in one conversion period. The following variables will be in our
mathematical treatment of compound interest
F =Maturity value of the loan or investment
P =Principal amount of the loan or investment
I= Amount of interest paid or received
J= Nominal interest rate
M= Number of conversion per year
T= time period (term) of the loan or investment
I =Periodic interest rate
N =number of conversions of the loan

The formula for the maturity value of a compound interest will be derived. The symbol
P and F are again used to represent the principal amount and maturity, respectively, of
the loan or investment. The general problem is to determine the maturity value at the
end of n conversion periods if periodic interest at the rate i is earned each period. The
periodic interest rate i is computed by dividing the nominal interest rate by the number
of conversion per year (in symbol i = j/m). On the other hand, numbers of conversions
of the loan n is the product of time period and number of conversion per year (in
symbol n=tm).
 Derivation of compound interest formula

And with the use of mathematical manipulation of the formula we will arrive with the other compound
interest formulas:
Computing the future value
Example 1. What will be the maturity value of P12,000 invested for 4 years at 15% compounded
quarterly?