Compound Interest (First Part)
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ScribdTranslationsCompound Interest (First Part)
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ScribdTranslationsCompound Interest
Compound Interest
In simple interest, the original capital on which it is
the interest remains unchanged for
the entire time the operation lasts.
In compound interest, on the other hand, the interest that is
are being generated, they are increasing the original capital in
established periods and, in turn, will generate new interest
additional for the following period.
In compound interest calculations, the interest
corresponding to a period of interest, is calculated on the
principal, plus the total amount of interest accrued in
previous periods. Therefore, compound interest
means 'interest on interest', that is, it reflects the effect of
value of money over time.
It is said then that interest is capitalized and that one is in
presence of a compound interest operation.
In these operations, the capital is not constant throughout the
time, as it increases at the end of each period by the addition
from the interest earned according to the agreed rate.
Example.
If a loan of $1,000 is requested at compound interest
of 6% annually, calculate the total amount owed after a
period of 3 years
The concept of payment can also be illustrated by considering
different payment schemes for a loan. Each plan
represents the payment of a loan of $5,000 in 5 years with a rate
an interest rate of 15% per year.
Plan 1. Neither the principal nor the interest is recovered until the fifth year.
Every year, interest is accumulated on the total of the principal and interest.
previously accumulated.
•Plan 2. The interest owed is paid each year and the principal is
recovers at the end of the fifth year.
Plan 3. The interest owed and 20% of the principal, that is, $1,000
se pagan cada año. Como el saldo adeudado decrece cada año, el
owed interest also decreases.
•Plan 4. Each year, equal payments are made, a part of which is
directed to the amortization of the principal and the rest to cover the interest
debtor.
Different payment schemes of $5,000 at 15% over 5 years
Symbols and meaning
i = Interest rate per interest period, % per month, %
per year.
n = Number of interest periods (in compound interest).
P = Value or sum of money at a specified time as
the present.
F = Value or sum of money in some future time.
A = A consecutive and periodic series (monthly, yearly,
etc.) of amounts of money at the end of the period.
G = Uniform increase or decrease over the following period
period
Interest formulas that relate sums to each other
current and future money
a) Find F when P is known
By the concept of equivalence, we know that
A peso today is equivalent to (1+i) pesos in a
year.
In addition, each peso at time t=1 is equivalent to
(1+i) pesos at time t=2, such that a
weight at time t=0, is equal to (1+i)(i+i) = (1+i)2
weights at time t=2
In general, a weight will have to be considered over time.
t=0 is equivalent to (1+i)npesos at time t=n.
The cash flow diagram that illustrates this relationship is
If we consider that the capital is P instead of 1, the formula for
to find the future value given the present value will be
F = P (1+i)n oF = P(F/P,i%,n)
a) Find F when P is known
b) Find P when F is known
c) Find F when A is known
d) Find A when F is known
e) Find P when A is known
f) Find A when P is known
g) Find F when G is known
h) Find P when G is known
i) Find A when G is known
Interest formulas that link uniform series of payments,
with its current or future value
We need to take the following considerations into account:
There is a period of interest before the first A.
F takes place on the same date as the last A and N periods.
after P
Find P/A and A/P
Find A/F and F/A
Exercises
1.- If $500 is deposited in a bank savings account, how much will there be in the account?
In three years, if the bank pays 4% interest compounded annually?
2.-If you want to have $800 in a savings account at the end of 4 years and you pay the
5% annual interest, what amount should be placed in the account now?
3.- Suppose you buy a stock for $10 and sell it for $20; your profit is, therefore,
so much, $10. If this happens in 5 years, what would be the rate of return on your
investment?
4.- You have just purchased 100 shares of General Electric at $30 each. You will sell the
actions when their market value doubles. If you expect the stock price
if it increases by 12% annually, how long do you plan to wait before selling the
actions?
5.- A person deposits $500 into a trust at the end of each year for 5 years. The
The trust pays 5% interest compounded annually. How much money will it have in its
account at the end of the 5 years immediately after your last deposit?
6.- How much money would you be willing to pay now for a promissory note that will produce $600?
annually for 9 years starting next year if the interest rate is 7% per year?
7.- How much money should a person deposit annually starting in one year?
At 5.5% annual interest to accumulate $6000 in 7 years?
8.- A couple aims to start saving money by depositing $500 into their account.
savings within a year. They calculate that deposits will increase by $100 per year
for 9 years, from then on. What would be the present value of the investments, if the
Is the interest rate 5% per year?
Exercises
1.- If $500 are deposited in a bank savings account, how much will be in the account?
In three years, if the bank pays 4% interest compounded annually?
2.-If you want to have $800 in a savings account at the end of 4 years and you pay the
5% annual interest, what amount should be deposited in the account now?
3.- Suppose you buy a stock for $10 and sell it for $20; your profit is, therefore
so, $10. If this happens in 5 years, what would be the rate of return on your investment?
investment?
4.- You have just purchased 100 shares of General Electric at $30 each. You will sell the
stocks when their market value doubles. If you expect the stock price
if it increases by 12% annually, how long do you plan to wait before selling the
actions?
5.- A person deposits $500 in a trust at the end of each year for 5 years. The
The trust pays 5% interest compounded annually. How much money will it have in its
amount at the end of the 5 years immediately after their last deposit?
6.- How much money would you be willing to pay now for a promissory note that will produce $600?
annually for 9 years starting from next year if the interest rate is 7% per year?
7.- How much money should a person deposit annually starting in one year?
at 5.5% annual interest to accumulate $6000 within 7 years?
8.- A couple plans to start saving money by depositing $500 into their account.
savings within a year. They estimate that deposits will increase by $100 per year
for 9 years, thereafter. What would be the present value of the investments, if the
Is the interest rate 5% per year?
Capitalization frequency of
interests
Nominal and effective interest
Many loan operations stipulate that the interest is compounded and
chargeable more frequently than once a year.
Consider the operation of a loan in which interest is charged at 1%
monthly. Occasionally, such an operation is described as a rate of
12% annual interest. More precisely, this rate should be described
as a 12% nominal annual interest rate capitalized monthly.
If the interest is expressed without any mention of its capitalization, it
understand that this occurs annually.
Capitalization period
Interest can be converted into annual, semi-annual, quarterly, and
monthly, etc. This period is referred to as the 'period of'
capitalization. To the number of times that the interest is capitalized during a
year is referred to as conversion frequency.
What is the conversion frequency of a bank deposit that pays 5%
of interest compounded quarterly?
Year 12 months
= = 4
Quarter 3 months
The conversion frequency is equal to 4. The capitalization period is
quarterly.
Suppose the interest rate is 12% compounded quarterly.
In this case, it is understood that the 12% is the annual nominal interest.
The capitalization periods in the year are 4. Therefore, the interest rate for
the period is 12/4 = 3% per quarter.
The effective interest rate is the effective annual rate taking into account the
capitalization of interest that occurs during the year. The effective rate of
annual interest is calculated
Where:
M = Number of compounding periods in the year
r = Nominal annual interest rate
Effective rate = (F/P,r/M, M) - 1
The capitalization period and the compound interest rate must always be
be equivalent.
Two conclusions can be drawn at this time:
a) Compound interest is greater than simple interest. This is the result,
well, the first one earns interest by itself, while the second one
no.
b) The higher the conversion frequency, the greater the interest that will be obtained
with the nominal annual rate being the same; thus, a bank deposit that
obtaining interest monthly will yield greater returns than one
that he obtains them quarterly and this, in turn, will be greater than another
that they obtain it every semester.
Compound Interest Problems
1.-What capital should be invested in an account that pays 33.6%?
annual capitalizable monthly, to have $13,000
in 7 months?
2.- How much accumulates in a savings account that yields the
18.6% annual capitalizable bimonthly for a term of 2
years, if $35,000 is invested?
3.- How long will it take to settle a loan of $175,000 with
24.96% interest compounded biweekly and one payment at
final of $230,000?
4.- A television whose price is $4,500 is being liquidated at $5,200.
the three months, what is the annual capitalizable interest rate
biweekly?
