LEARNING MODULE IN APPLIED MATHEMATICS OF INVESTMENT

COMPOUND
INTEREST

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 LEARNING MODULE IN APPLIED MATHEMATICS OF INVESTMENT

Topic Objectives:
At the end of this lesson, you are expected to:
Describe the nature of compound interest; and
Solve problems involving compound interest.

Let’s Look Back!

In the previous lesson, simple interest has been discussed as a type of interest.
You have learned that it is computed entirely on the original principal by simply
multiplying together the principal, rate, and time (I=PRT).
Suppose you borrowed Php 1,000 from a student-loan program which charges
12% for one year. How much is the interest that you have to pay?
To solve the problem:
Given:
P= 1,000
R= 12% or .12
T= 1 year
Solution:
I= PRT
I= (1,000)(.12)(1)
I= Php120
With interest of Php120, you have to pay Php1,120 (1,000+120) at the end of the
1 year term of the loan.
Simple interest is the type of interest commonly used for short-term loans or
investments having a term of 1year or less. However, for long-term
obligations/investments, interest is added to the principal and the resulting amount
becomes the new principal for the next interest period. This is called compound interest.
You will learn more about this as we proceed with this lesson.

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 LEARNING MODULE IN APPLIED MATHEMATICS OF INVESTMENT

Let’s Learn!

3.1 Definitions

Compound amount (F) – also called maturity value at the end of term, it is an
accumulated amount obtained by adding the principal and the compound
interest.

Conversion period (m) – also known as interest period, is the number of times
in a year the interest will be compounded.

Number of conversion periods (n) – the total number of times interest is

calculated for the entire term of the investment or loan.

Annual interest rate or nominal rate (r) – the stated rate of interest per year.

Periodic rate (i) – the interest rate per conversion period.

Present value of F (P) – this is the principal P, that will accumulate to F if there
is an interest at periodic rate i for n conversion periods.

3.2 Nature of Compound Interest

Very few banks today pay interest based on the simple interest formula. Instead, they
pay interest by using a principle called compounding. Compound interest refers to the sum of
interests’ prior periods computed on the original or principal amount and each of successive
periods on both the principal and interest. It is earned on a given deposit that has become part of
the principal at the end of a specified period.

Compound Interest is actually simple interest calculated repeatedly with a principal

which is increased by the simple interest earned after each period.

Unlike simple interest, compound interest on an amount accumulates at a faster rate

than simple interest. The basic idea is that after the first interest period, the amount of interest is
added to the principal amount and then the interest is computed on this higher principal. The
result is a much faster growth of money than simple interest would yield.

The process of adding the interest due to the new principal in succeeding periods
continues until the due date is known as compounding amount.

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 LEARNING MODULE IN APPLIED MATHEMATICS OF INVESTMENT

Illustration: Compare the simple interest and the compound interest on a 20,000 loan @ 10%
interest for 3 years.

Solution:

Simple Interest

Simple interest @ 10% for 3 years

= 20,000 (.10) (3)

= 6,000.00

Accumulated amount after 3 years

= 20,000 + 6,000

= 26,000

Compound Interest

First annual interest = 20,000 (.10)

= 2,000

New principal for the 2nd year = (20,000) + (2,000)

= 22,000

Second annual interest = (22,000) (.10)

= 2,200

New principal for the 3rd year = (22,000) + (2,200)

= 24,200

Third annual interest = (24,200) (.10)

= 2,420

Interest after 3 years: 2,000 + 2,200 + 2,420 = 6,620

Simple Interest Compound Interest

Year
Beg. Bal. Interest Ending Bal. Beg. Bal. Interest Ending Bal.
1 20,000.00 2,000.00 22,000.00 20,000.00 2,000.00 22,000.00
2 22,000.00 2,000.00 24,000.00 22,000.00 2,200.00 24,200.00
3 24,000.00 2,000.00 26,000.00 24,200.00 2,420.00 26,620.00

The compound interest is greater than the simple interest by 620. It follows that
the accumulated amount at compound interest is also greater than that at simple interest
as shown in the computations. Thus, the loan amount due at compound interest
increases rapidly than at simple interest.

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 LEARNING MODULE IN APPLIED MATHEMATICS OF INVESTMENT

3.3 The Term and the Number of Conversion Periods

The term (t) is the length of time compounding takes place. The total number of
conversion periods (n) is the product of the term (t) given in years and the frequency of
conversion in one year (m). That is n = tm

The following are the common conversion periods in a year:

 annually : m = 1

 semi-annually : m = 2

 quarterly : m = 4

 monthly : m = 12

 every 4 months: m = 3

 every 2 months: m = 6

Thus, if the term is 2 years and interest is compounded quarterly, the number of
conversion periods is 8.

n = tm

n = (2) (4)

n=8

Example: Joe invested a sum of money for 6 years with interest compounded monthly. Fine the
number of conversion period for the whole term.

Given: t = 6 years m = 12

Solution:

n = tm

n = (6)(12)

n = 72

3.4 The Interest Rate per Conversion Period or Periodic Rate

The interest rate per conversion period (i) is the rate used to compute the periodic
interest. So, the rate 10% compounded quarterly has an interest rate of 2.5% per period.
Nominal rate should be changed to interest rate per conversion period, thus,
Interest rate per conversion period (i) = nominal annual rate (j) /
Frequency of conversion in one year (m)
i = j/m

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 LEARNING MODULE IN APPLIED MATHEMATICS OF INVESTMENT

Example: If Ann invested her money at 10% compounded quarterly, what is the interest rate
per conversion period?

Given: j = 10% m=4

Solution:

i = j/m

i = 10% / 4

i = .025 or 2.5%

3.5 The Compound Amount

Compound amount is the accumulated value of the principal and all interest amounts
prior periods. In other words, it is the sum of the principal and all compound interest.
The general formula for compound amount is:
F = P (1+i)ⁿ

Where: F = compound amount at compound interest

P = original principal (present value)
i = interest rate per conversion period (periodic rate)
n = total number of conversion periods

The quantity (1+ i)ⁿ is called the accumulated factor. It is also the compound amount of P1.

Example 1: Find the compound amount of 12,500 at 12% compounded quarterly for 5 years.

Given: P = 12,500 j = 12% m=4 t=5

Solution:

i = j/m n = tm

=12%/4 = (5) (4)

i = 3% or .03 n = 20

F = P(1+i)ⁿ

= 12,500 (1+ .03)20

= 22,576.39

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 LEARNING MODULE IN APPLIED MATHEMATICS OF INVESTMENT

Example 2: Grace and Donna deposited Php8,000 in a savings account at 5%. If interest is
compounded monthly, what will the amount of their deposit be at the end of two years?

Given: P = 8,000 j = 5% m = 12 t=2

Solution:

i = j/m n = tm

=5%/12 = (2) (12)

i = .004167 n = 24

F = P(1+i)ⁿ

= 8,000 (1+ .004167)24

= 8, 839.39

3.6 The Compound Interest

In finding the compound interest, the following formulas can be used:

I=F–P
or
I = P[(1 + i)n − 1]

where I = compound Interest

F = compound amount
P = original principal
i = interest rate per conversion period (periodic rate)
n = total number of conversion periods

Example: Find the interest earned on 15,000.00 for 1 year at 7% compounded semi-annually.

Given: P = 15,000 j = 7% m=2 t=1

i = j/m n = mt

= 7%/2 = (2) (1)

i = .035 n=2

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 LEARNING MODULE IN APPLIED MATHEMATICS OF INVESTMENT

Solution:

I = P[(1 + i)n − 1]
I = 15,000.00[(1 + 0.035)2 − 1]

I = 𝟏, 𝟎𝟔𝟖. 𝟑8

3.7 Finding the Interest Rate

The computation in finding the interest rate centers on the basic formula of compound
amount where the factor (1+i)n is an element.
The variable i in the factor (1+i)n is the periodic interest rate. It is compounded by
dividing the nominal rate by the compounding periods. To compute for the nominal rate, the
periodic rate is simply multiplied to the compounding periods. Hence:
Nominal rate (r)= Periodic rate (i) x Compounding period (n)

To solve for i, the formula is:

i= (C/P) 1/n - 1
where:
C = Compound amount or future amount
P = Principal or present value
n = Total number of compounding periods

Example: At what rate, compounded quarterly, will 15,000 become 35,000 at the end of 12
years?

Given: Principal = 15,000.00

Compound amount = 35,000.00
Terms = 12 years
Frequency of conversion = 4 (quarterly)
Total compounding periods = 48

Solution: i= (C/P) 1/n – 1

= (35,000/15,000)1/48 – 1
= 1.017808 -1
= .017808

r= .017808 x 4
= 0.071232
= 7.12%

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 LEARNING MODULE IN APPLIED MATHEMATICS OF INVESTMENT

3.8 Finding the Time

The number of compounding periods is computed from the basic formula of compound
amount C = P (1+i)n. From the process of derivation, the formula to compute for compounding
periods is:

n= log C – log P / log (1+i) or n= log C/P

log(1+i)

T = log C – log P
flog(1+i)

where: n = Total number of compounding periods

C = Compound or future amount
P = Principal or present value
f= frequency of conversion
i= Periodic interest rate
T = Time or term

Example: How long will it take for 25,000 to accumulate to 50,000 at 10% compounded
quarterly?

Given: Principal or present value = 25,000

Compound amount = 50,000
Nominal rate = 10%
Frequency of conversion = 4 (quarterly)
Periodic interest rate = 2.5%

Solution: n = log C – log P

log(1+i)
= log 50,000 – log 25,000 / log (1-0.025)
= 4.698970 – 4.397840 / 0.010724
= 28.07

T = 28.07/4
= 7.02 years

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 LEARNING MODULE IN APPLIED MATHEMATICS OF INVESTMENT

Let’s Try!
Problem Solving
Instruction: Solve the following problems. Show your solution.

1. What is the total number of conversion periods when a certain sum of money is
borrowed at 8% compounded monthly for 5 years?

2. Find the compound amount of 35,000.00 at 7% interest compounded semi-annually

for 2 years.

3. Find the interest on 55,750.00 for 4 years at 8% compounded quarterly.

4. What is the periodic rate or interest rate per conversion period if 29,500.00 was
invested at 12% compounded semi-annually for 8 years?

5. If 90,000 is invested at 5% compounded quarterly, how much will the investment be

worth after 4 years?

6. Rey invested 40,000.00 in a time deposit that pays 12% compounded monthly. How
much interest will he gain after 3 years?

7. A man borrowed 150, 000 at 8% compounded semi-annually. How much will he

have to pay at the end of 8 years?

8. Lyn borrows 60,000.00 and promise to pay the principal and interest at 12%
compounded monthly. How much must she repay after 4 years?

9. How much must be invested today in a savings account in order to have ₱50,800.00
in 6 years and 9 months if money earns 5.4% compounded semi-annually?

10. A man died leaving his 10 year-old son an amount of 50,000 which is deposited in a
bank at 8% interest compounded quarterly. If money was left in the bank and was
allowed to accumulate, how much will the boy receive when he reaches the age of
20?

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 LEARNING MODULE IN APPLIED MATHEMATICS OF INVESTMENT

References:

Aduana, N. L. (2012). Mathematics of Investment: Procedural Approach. C & E

Publishing, Inc.

Calmorin, L.P., Malubay, H.A. & Deloso, M. P. (2012. Mathematics of Investment

with computer application. Rex Book Store, Inc.

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