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Compound Interest Formula Derivations

Showing how the formulas are worked out, with Examples!

With Compound Interest, you work out the interest for the first period, add it to the total, andthen calculate the
interest for the next period, and so on ..., like this:

Make A Formula
Let's look at the first year to begin with:

$1,000.00 + ($1,000.00 × 10%) = $1,100.00

We can rearrange it like this:

So, adding 10% interest is the same as multiplying by 1.10

(Note: the Interest Rate was turned into a decimal by dividing by 100: 10% = 10/100 = 0.10, read Percentages to
learn more.)

And that formula works for any year:

· We could do the next year like this: $1,100 × 1.10 = $1,210

· And then continue to the following year: $1,210 × 1.10 = $1,331
· etc...

So it works like this:

In fact we could go straight from the start to Year 5 if we multiply 5

times:

$1,000 × 1.10 × 1.10 × 1.10 × 1.10 × 1.10 = $1,610.51

But it is easier to write down a series of multiplies using Exponents (or Powers) like this:

The Formula
We have been using a real example, but let us make it more general by using letters instead of numbers, like this:

(Can you see it is the same? Just with PV = $1,000, r = 0.10, n = 5, and FV = $1,610.51)

Examples

How about some examples ... 

... what if the loan went for 15 Years? ... just change the "n" value:

... and what if the loan was for 5 years, but the interest rate was only 6%? Here:
The Four Formulas
So, the basic formula for Compound Interest is:

To find the Future Value, where:

FV = PV (1+r)n
 FV = Future Value,
 PV = Present Value,
 r = Interest Rate (as a decimal value), and
 n = Number of Periods

With that we can work out FV when we know PV, the Interest Rate and Number of Periods

But by rearranging that formula we can find FV, the Interest Rate or the Number of Periods when we know the
other three, like this:

   
Find the Present Value when you know a Future Value,
PV = FV / (1+r)n the Interest Rate and number of Periods.

   
Find the Interest Rate when you know the Present
r = ( FV / PV )1/n - 1 Value, Future Value and number of Periods.

   
Find the number of Periods when you know the Present
n = ln(FV / PV) / ln(1 + r) Value, Future Value and Interest Rate

How did we get those other three formulas? Read On!

Working Out the Present Value

Let's say you want to reach $2,000 in 5 Years at 10%. How much should you start with?

In other words, you know a Future Value, and want to know a Present Value.

We can just rearrange the formula to suit ... dividing both sides by (1+r)n to give us:
So now we can calculate the answer:

PV = $2,000 / (1+0.10)5 = $2,000 / 1.61051 = $1,241.84

It works like this:

Another Example: How much would you need to invest now, to get $10,000 in 10 years at 8% interest
rate?
PV = $10,000 / (1+0.08)10 = $10,000 / 2.1589 = $4,631.93
So, $4,631.93 invested at 8% for 10 Years would grow to $10,000

Working Out The Interest Rate

If you have $1,000, and want it to grow to $2,000 in 5 Years, what interest rate do you need?

We need a rearrangement of the first formula to work it out.

Now we have the formula, it is just a matter of "plugging in" the values to get the result:
 r = ( $2,000 / $1,000 )1/5 - 1 = ( 2 )0.2 - 1 = 1.1487 - 1 = 0.1487

And 0.1487 as a percentage is 14.87%,

So you would need a 14.87% interest rate to turn $1,000 into $2,000 in 5 years.

Another Example: What interest rate would you need to turn $1,000 into $5,000 in 20 Years?
r = ( $5,000 / $1,000 )1/20 - 1 = ( 5 )0.05 - 1 = 1.0838 - 1 = 0.0838
And 0.0838 as a percentage is 8.38%. So 8.38% will turn $1,000 into $5,000 in 20 Years.

Working Out How Many Periods

If you want to know how many periods it will take to turn $1,000 into $2,000 at 10% interest, you can also
rearrange the basic formula.

But we need to use the natural logarithm function ln() to do it.

Now let's "plug in" the values:

n = ln( $2,000 / $1,000 ) / ln( 1 + 0.10 ) = ln(2)/ln(1.10) = 0.69315/0.09531 = 7.27

Magic! It will need 7.27 periods to turn $1,000 into $2,000 at 10% interest.

Another Example: How many years to turn $1,000 into $10,000 at 5% interest?

n = ln( $10,000 / $1,000 ) / ln( 1 + 0.05 ) = ln(10)/ln(1.05) = 2.3026/0.04879 = 47.19
47 Years! But we are talking about a 10-fold increase, at only 5% interest.

Conclusion
Now that you see how each formula was derived and how to use it, hopefully it will be easier for you to remember
them, and to be able to use them in different situations.
  
Introduction to InterestInvestment GraphCompound Interest CalculatorMoney Index

Present value
From Wikipedia, the free encyclopedia

Present value is the value on a given date of a future payment or series of future
payments, discounted to reflect the time value of money and other factors such
as investment risk. Present value calculations are widely used in business and economics
to provide a means to compare cash flows at different times on a meaningful "like to like"
basis.

Background
If offered a choice between $100 today or $100 in one year and there is a positive real
interest rate throughout the year ceteris paribus, a rational person will choose $100 today.
This is described by economists as Time Preference. [citation needed] Time Preference can be
measured by auctioning off a risk free security - like a US Treasury bill. If a $100 note,
payable in one year, sells for $80, then the present value of $100 one year in the future is
$80. This is because you can invest your money today in a bank account or any other (safe)
investment that will return you interest. [clarification needed]

An investor who has some money has two options: to spend it right now or to save it. But
the financial compensation for saving it (and not spending it) is that the money value will
accrue through the interest that he or she will receive from a borrower (the bank account on
which he has the money deposited).

Therefore, to evaluate the real value of an amount of money today after a given period of
time, economic agents compound the amount of money at a given (interest) rate. Most
actuarial calculations use the risk-free interest rate which corresponds the minimum
guaranteed rate provided by your bank's saving account for example. If you want to
compare your change in purchasing power, then you should use the real interest
rate (nominal interest rate minus inflation rate).
The operation of evaluating a present value into the future value is called a capitalization
(how much $100 today are worth in 5 years?). The reverse operation—evaluating the
present value of a future amount of money—is called a discounting (how much $100 that I
will receive in 5 years—at a lottery for example—are worth today?).

It follows that if one has to choose between receiving $100 today and $100 in one year, the
rational decision is to choose the $100 today. If the money is to be received in one year and
assuming the savings account interest rate is 5%, the person has to be offered at least
$105 in one year so that two options are equivalent (either receiving $100 today or receiving
$105 in one year). This is because if you cash $100 today and deposit in your savings
account, you will have $105 in one year.

Calculation
The most commonly applied model of the time value of money is compound interest. To
someone who can lend or borrow for   years at an interest rate   per year (where interest of
"5 percent" is expressed fully as 0.05), the present value of the receiving   monetary
units   years in the future is:

This is also found from the formula for the future value with negative time.

The purchasing power in today's money of an amount C of money, t years into the

future, can be computed with the same formula, where in this case i is an assumed
future inflation rate.

The expression   enters almost all calculations of present value. Where the
interest rate is expected to be different over the term of the investment, different values
for   may be included; an investment over a two year period would then have PV of:

Technical details
Present value is additive. The present value of a bundle of cash flows is the sum
of each one's present value.

In fact, the present value of a cash flow at a constant interest rate is

mathematically the same as the Laplace transform of that cash flow evaluated with
the transform variable (usually denoted "s") equal to the interest rate. For discrete
time, where payments are separated by large time periods, the transform reduces
to a sum, but when payments are ongoing on an almost continual basis, the
mathematics of continuous functions can be used as an approximation.

Variants/Approaches
There are mainly two flavors of PV. Whenever there will be uncertainties in both
timing and amount of the cash flows, the expected present value approach will
often be the appropriate technique.

 Traditional Present Value Approach - in this approach a single set of

estimated cash flows and a single interest rate (commensurate with the risk,
typically a weighted average of cost components) will be used to estimate the
fair value.

 Expected Present Value Approach - in this approach multiple cash flows

scenarios with different/expected probabilities and a credit-adjusted risk free
rate are used to estimate the fair value.
Choice of interest rate
The interest rate used is the risk-free interest rate. If there are no risks involved in
the project, the rate of return from the project must equal or exceed this rate of
return or it would be better to invest the capital in these risk free assets. If there
are risks involved in an investment this can be reflected through the use of a risk
premium. The risk premium required can be found by comparing the project with
the rate of return required from other projects with similar risks. Thus it is possible
for investors to take account of any uncertainty involved in various investments.

]Annuities, perpetuities and other common forms

Many financial arrangements (including bonds, other loans, leases, salaries,
membership dues, annuities, straight-line depreciation charges) stipulate
structured payment schedules, which is to say payment of the same amount at
regular time intervals. The term "annuity" is often used to refer to any such
arrangement when discussing calculation of present value. The expressions for
the present value of such payments are summations of geometric series.

A cash flow stream with a limited number (n) of periodic payments (C), receivable
at times 1 through n, is an annuity. Future payments are discounted by the
periodic rate of interest (i). The present value of this ordinary annuity is determined
with this formula:[1]

 
where:

 = number of years

 = Amount of cash flows

This formula is usable when the cash flows are spread over the different but
in equal intervals and also the amount of these flows is same say $100 at the
end of each year from year one to ten. the   is defined as interest rate /
required rate of return[2]

A periodic amount receivable indefinitely is called a perpetuity, although few

such instruments exist. The present value of a perpetuity can be calculated
by taking the limit of the above formula as n approaches infinity. The
bracketed term reduces to one leaving:

The first formula is found from subtracting from the latter result the
present value of a perpetuity delayed n periods.

These calculations must be applied carefully, as there are underlying

assumptions:

 That it is not necessary to account for price inflation, or alternatively,

that the cost of inflation is incorporated into the interest rate.
 That the likelihood of receiving the payments is high — or,
alternatively, that the default risk is incorporated into the interest rate.
See time value of money for further discussion.
Future value
From Wikipedia, the free encyclopedia

Future value is the value of an asset at a specific date.[1] It measures the nominal future
sum of money that a given sum of money is "worth" at a specified time in the future
assuming a certain interest rate, or more generally, rate of return; it is the present
value multiplied by the accumulation function[2]. The value does not include corrections for
inflation or other factors that affect the true value of money in the future. This is used in time
value of money calculations.

Overview
Money value fluctuates over time: $100 today is not worth $100 in five years. This is
because one can invest $100 today in a bank account or any other investment, and that
money will grow/shrink due to interest. Also, if $100 today allows the purchase of an item, it
is possible that $100 will not be enough to purchase the same item in five years, because
of inflation (increase in purchase price).

An investor who has some money has two options: to spend it right now or to invest it. The
financial compensation for saving it (and not spending it) is that the money value will accrue
through the interests that he will receive from a borrower (the bank account on which he has
the money deposited).

Therefore, to evaluate the real worthiness of an amount of money today after a given period
of time, economic agents compound the amount of money at a given interest rate.
Most actuarial calculations use the risk-free interest rate which corresponds the minimum
guaranteed rate provided the bank's saving account, for example. If one wants to compare
their change in purchasing power, then they should use the real interest rate (nominal
interest rate minus inflation rate).

The operation of evaluating a present value into the future value is called
a capitalization (how much will $100 today be worth in 5 years?). The reverse operation
which consists in evaluating the present value of a future amount of money is called
a discounting (how much $100 that will be received in 5 years- at a lottery, for example -are
worth today?).
It follows that if one has to choose between receiving $100 today and $100 in one year, the
rational decision is to cash the $100 today. If the money is to be received in one year and
assuming the savings account interest rate is 5%, the person has to be offered at least
$105 in one year so that two options are equivalent (either receiving $100 today or receiving
$105 in one year). This is because if you cash $100 today and deposit in your savings
account, you will have $105 in one year.

Simple interest
To determine future value (FV) using simple interest (i.e., without compounding):

where PV is the present value or principal, t is the time in years (or a fraction of year),
and r stands for the per annum interest rate. Simple interest is rarely used, as
compounding is considered more meaningful. Indeed, the Future Value in this case
grows linearly (it's a linear function of the initial investment): it doesn't take into account
the fact that the interest earned might be compounded itself and produce further
interest (which corresponds to an exponential growth of the initial investment -see
below-).

Compound interest
To determine future value using compound interest:
[3]

where PV is the present value, t is the number of compounding periods (not

necessarily an integer), and i is the interest rate for that period. Thus the future
value increases exponentially with time when i is positive. The growth rate is given
by the period, and i , the interest rate for that period. Alternatively the growth rate
is expressed by the interest per unit time based on continuous compounding. For
example, the following all represent the same growth rate:

 3 % per half year

 6.09 % per year (effective annual rate, annual rate of return, the standard way
of expressing the growth rate, for easy comparisons)
 2.95588022 % per half year based on continuous compounding (because ln
1.03 = 0.0295588022)
 5.91176045 % per year based on continuous compounding (simply twice the
previous percentage)
Also the growth rate may be expressed in a percentage per period (nominal rate),
with another period as compounding basis; for the same growth rate we have:

 6% per year with half a year as compounding basis

To convert an interest rate from one compounding basis to another compounding
basis (between different periodic interest rates), the following formula applies:

where i1 is the periodic interest rate with compounding frequency n1 and i2 is

the periodic interest rate with compounding frequency n2.

If the compounding frequency is annual, n2 will be 1, and to get the annual

interest rate (which may be referred to as the effective interest rate, or
the annual percentage rate), the formula can be simplified to:

where r is the annual rate, i the periodic rate, and n the number of

compounding periods per year.

Problems become more complex as you account for more variables. For
example, when accounting for annuities (annual payments), there is no
simple PV to plug into the equation. Either the PV must be calculated
first, or a more complex annuity equation must be used. Another
complication is when the interest rate is applied multiple times per
period. For example, suppose the 10% interest rate in the earlier
example is compounded twice a year (semi-annually). Compounding
means that each successive application of the interest rate applies to all
of the previously accumulated amount, so instead of getting 0.05 each 6
months, one must figure out the true annual interest rate, which in this
case would be 1.1025 (one would divide the 10% by two to get 5%, then
apply it twice: 1.052.) This 1.1025 represents the original amount 1.00
plus 0.05 in 6 months to make a total of 1.05, and get the same rate of
interest on that 1.05 for the remaining 6 months of the year. The second
six month period returns more than the first six months because the
interest rate applies to the accumulated interest as well as the original
amount.

This formula gives the future value (FV) of an ordinary annuity (assuming

compound interest):[4]

where r = interest rate; n = number of periods. The simplest way to

understand the above formula is to cognitively split the right side of
the equation into two parts, the payment amount, and the ratio of
compounding over basic interest. The ratio of compounding is
composed of the aforementioned effective interest rate over the
basic (nominal) interest rate. This provides a ratio that increases the
payment amount in terms present value.