LESSON 5: COMPOUND INTEREST and COMPOUND AMOUNT

Compounding is the concept that any amount earned on an investment can be reinvested to
create additional earnings that would not be realized based on the original principal, or original balance,
alone. The interest on the original balance alone would be called simple interest. The additional
earnings plus simple interest would equal the total amount earned from compound interest.

In other words, an investment earns compound interest when the interest from each time
period is added to the principal, and then earns interest in the following time periods. As the principal
grows, the rate at which you earn interest grows as well, because you are earning “interest on interest”.
Compounding makes a significant difference in the final value of an investment. Compounding increases
the amount you earn when investing, but increases the costs when you borrow money.

The compound interest formula calculates the amount of interest earned on an account or
investment where the amount earned is reinvested. By reinvesting the amount earned, an investment
will earn money based on the effect of compounding.

Illustrative Example:

1. A vendor deposits P5,000.00 in a savings account earning 2% interest compounded annually.

Solution:
Compounded annually means that the interest will be calculated once a year.
I =Prt=( 5,000 ) ( .02 )( 1 )=P 100.00
At the end of one year, her money on bank will be
M =P+ I =5,000+100=P5,100.00
During its second year,
I =Prt=( 5,100 ) ( .02 )( 1 )=P 102.00
At the end of the second year, the total amount in the account is
M =P+ I =5,100+102=P 5,202.00
The interest earned during the third year is calculated using the amount in the account at the
end of the second year (P5,202.00)
I =Prt=( 5,202 )( .02 ) ( 1 )=P 104.04
Notice that the interest earned every year increases. This is what compound interest is all about.
However, compound interest is not only limited to annually, we also have semi-annually or
twice a year, quarterly or four times a year, monthly or even daily. We call this frequency as
compounding period.

For instance, if the interest is compounded semi-annually, meaning the first interest payment
occurs after 6 months and the earned interest is added to the account.

Interest earned after 6 months;

I =Prt=( 5,000 ) ( .02 ) ( 126 )=P50.00

M =P+ I =5,000+50=P5,050.00

Interest earned after the second six months

 6
I =Prt=( 5,050 ) ( .02 )
12 ( )
=P50.50

M =P+ I =5,050+50.50=P5,100.50
The total amount in the account at the end of the first year is P5,100.50 which is called
compound amount.

Compound Amount Formula:

( )
nt
r
M =P 1+
n
Where:

M = compound amount
P = amount of money deposited
r = annual interest rate
n = number of compounding periods per year
t = number of year

Examples:

1. Mr. Tabaranza deposited P15,000 in an account earning 5% interest, compounded quarterly, for
a period of 2 years.

Solution:

( ) ( )
nt (4)(2)
r .05
M =P 1+ =15,000 1+ =16,567 .29 (compound amount after 2 years)
n 4

2. Calculate the future value of P7,500 earning 9% interest, compounded daily (ordinary), for 3
years.

Solution:

( )
nt (360)(3)
r .09
M =P(1+ ) =7,500 1+ =P 9,824.40
n 360

3. How much interest is earned in 4 years on P8,000 deposited in an account paying 6% interest,
compounded semi-annually.

Solution:

( ) ( )
nt (2)(4)
r .06
M =P 1+ =8,000 1+ =P 10,134.16(compound amount )
n 2
I =M −P
I =10,134.16−8,000=P 2,134.16(interest earned)
EXERCISES:

1. Find the compound amount of P35,000.00 compounded semi-annually for 10 years at 15%.
2. Tom deposits P20,000.00 into an account with an interest rate of 2.5% that is compounded
quarterly. What is the balance in Tom’s account after 4 years?
3. An engineer deposited P18,000 in a savings account at 8%. If the interest is compounded
monthly, what will be the amount of the deposit at the end of five years?
4. Accumulate P5,600 for 3 years at 5 ½% compounded semi-annually?
5. How much money should be invested in an account that earns 6% interest, compounded
quarterly in order to have P25,500.00 in 3 years.