Course Code and Title: MAT100 – MATHEMATICS IN THE MODERN WORLD

Lesson 13 Week 13
Topic: COMPOUND INTEREST – PROBLEMS AND SOLUTIONS

COMPOUND INTEREST – PROBLEMS AND SOLUTIONS

INTRODUCTION:

Interest may be defined as the charge for using the borrowed money. It is an expense
for the person who borrows money and income for the person who lends money. Interest is
charged on principal amount at a certain rate for a certain period. For example, 10% per year,
4% per quarter or 2% per month etc. Principal amount means the amount of money that is
originally borrowed from an individual or a financial institution. It does not include interest.

Compounding of interest is very common. Under this method, the interest is charged
on principal plus any accumulated interest. The amount of interest for a period is added to
the amount of principal to compute the interest for next period. In other words, the interest is
reinvested to earn more interest. The interest may be compounded monthly, quarterly,
semiannually or annually.

LESSON OBJECTIVE:

At the end of the lesson, you should be able to:

● define and understand what compound interest is;

● compute diligently how to find the compound interest; and
● apply the knowledge of computing compound interest into real-life situations.
CONTENT:

Compound interest (or compounding interest) is the interest on a loan or deposit

calculated based on both the initial principal and the accumulated interest from previous
periods. Thought to have originated in 17th-century Italy, compound interest can be thought
of as "interest on interest," and will make a sum grow at a faster rate than simple interest,
which is calculated only on the principal amount.

The rate at which compound interest accrues depends on the frequency of

compounding, such that the higher the number of compounding periods, the greater the
compound interest. Thus, the amount of compound interest accrued on ₱100 compounded
at 10% annually will be lower than that on ₱100 compounded at 5% semi-annually over the
same time period. Because the interest-on-interest effect can generate increasingly positive
returns based on the initial principal amount, compounding has sometimes been referred to
as the "miracle of compound interest."

What Is Compound Interest? If during the term of investment, the interest due at
stated intervals is added to the principal and thereafter earns interest, the sum of the
increases over the principal by the end of the term of investment is called COMPOUND
INTEREST.

What is Compound Amount? At any date, the total amount due which consists of the
original principal and the compound interest is called COMPOUND AMOUNT.

What is Conversion Period? The time between the successive conversions of interest
into principal is called CONVERSION PERIOD. It is the number of unit of time in one year
as basis for computing interest which could be either: (a) annually, (b) semiannually, (c)
quarterly, or (d) monthly. It refers to the number of times in a year the interest will be
compounded.

Annually m=1 Monthly m = 12

Semiannually m= 2 Weekly m = 52

Quarterly m=4 Daily m = 360

 The formula is basically the same as that of simple interest, except the introduction of
two letter symbols; i and n.

i or r/n = represent interest rate per conversion period expressed as a

fraction or decimal.

n = represent the number of conversion periods within the term.

There are ample examples of compound interest. The following different compound
interest examples give an understanding of the most common type of situations where the
compound interest is calculated and how one can calculate the same. As there are multiple
areas and situations where the compound interest can be calculated, it is not possible to
provide all the types of examples. So, some of the examples of compound interest are given
below, showing the different situations.

Consider the following illustration to understand the whole procedure of compounding.

EXAMPLE 1: Anna puts ₱20,000 in an investment paying 8% annually. With an

interest compounded monthly at this rate, how much money will be
in her account after 10 years?
SOLUTION:
Given data: P = ₱20,000 t = 10 years
r = 8% or 0.08 n = 12 (monthly)
Find: A=?
 𝑟
A = P (1 + )nt
𝑛
0.08 12(10)
A = 20,000(1 + )
12

= 20,000 (1 + 0.006667)120
= 20,000 (2.219640233)
= 44,392.80
A = ₱44,392.80 is the amount of money that will be in Anna’s account
after 10 years.

EXAMPLE 2: Solve for the compound amount and the compound interest at the end
of 2 years if ₱10,000 is invested at 6% compounded semiannually.

SOLUTION:
Given data:
P = ₱10,000 t = 2 years
r = 6% or 0.06 n = 2 (semiannually)

Find: A=? and I = ?

𝑟
A = P (1 + )nt I=A-P
𝑛
0.06 2(2)
A = 10,000(1 + ) I = 11,255.09 – 10,000
2

= 10,000 (1 + 0.03)4 I = 1,255.09

= 10,000 (1.12550881)
= 11,255.09
A = ₱11,255.09 is the amount of money at the end of 2 years.
I = ₱1,255.09 is the compound interest of the invested money

EXAMPLE 3: Suppose ₱8,000 was invested at the rate of 12% compounded

quarterly for one year, how much is the compound amount and the
compound interest?
SOLUTION:

Given data:
P = ₱8,000 t = 1 year
r = 12% or 0.12 n = 4 (quarterly)
 Find: A = ? and I = ?
𝑟
A = P (1 + )nt I=A-P
𝑛
0.12 4(1)
A = 8,000(1 + ) I = 9,004.07 – 8,000
4

= 8,000 (1 + 0.03)4 I = 1,004.07

= 8,000 (1.12550881)
= 9,004.07
A = ₱9,004.07 is the amount of money at the end of 1 year.
I = ₱1,004.07 is the compound interest of the invested money.

EXAMPLE 4: Harold wants to have his ₱1,000,000 for retirement after 45 years. He
was advised to invest in a mutual fund paying on an average of 5.5%
every year compounded quarterly. He wants to find out how much he
should deposit into his mutual fund.
SOLUTION:
Given data: A = ₱1,000,000 t = 45 years
r = 5.5% or 0.055 n = 4 (quarterly)

Find: P=?
𝑟
A = P (1 + )nt
𝑛
0.055 4(45)
1,000,000 = P (1 + )
4

1,000,000 = P (1 + 0.01375)180
1,000,000 = P (11.68304634)
1,000,000 = P (11.68304634) = 85,594.12
11.68304634 11.68304634
P = ₱85,594.12 is the amount of money Harold should deposit.

EXAMPLE 5: Solve for the compound amount and the compound interest at the end
of 2 years if ₱5,000 is invested at 8% compounded annually.

SOLUTION:
Given data: A = P5,000 t = 2 years
 r = 8% or 0.08 n=1
Find: A = ? and I = ?
𝑟
A = P (1 + ) nt I=A-P
𝑛
0.08 1(2)
A = 5,000(1 + ) I = 5,832.00 – 5,000
1

= 5,000 (1 + 0.08)2 I = 832.00

= 5,000 (1.1664)
= 5,832.00
A = ₱5,832.00 is the amount of money at the end of 2 years.
I = ₱832.00 is the compound interest of the invested money.

EXAMPLE 6: Maria invests ₱50,000 into a fund averaging at 8.4% compounded

semiannually. At this rate, how many years must she wait for her
account to reach ₱1,000,000

SOLUTION: Given data: A = ₱1,000,000 P = ₱50,000

r = 8.4% or 0.084 n=2

Find: t = ?

From: A = P (1 + r/n)nt

1,000,000 = 50,000 (1 + 0.084/2) 2t

1,000,000 = 50,000 (1 + 0.042)2t

1,000,000 = 50,000 (1 + 0.042)2t

50,000 50,000

(1 + 0.042)2t = 20
log (1.024)2t = log 20
log An = n log A
2t log (1.042) = log 20__
log (1.042) log (1.042)

2t = __log 20___
Log (1.042)
 2t = 1.301029996
0.017867718

2t = 72.81455841
2 2

t = 36.40727921 or 36.4 years Maria must wait for her

account to reach ₱1,000,00.

Suppose you were given the future value, the time, and the number of compounding
periods, but you were asked to calculate the rate earned. This could be used in a situation
where you are taking the amount of home sold for and determining the rate earned, if it is
viewed as an investment. Consider the following example.

EXAMPLE 7: Mrs. Solis purchased an antique statue for ₱450. Ten years later, she
sold this statue for ₱750. If the statue is viewed as an investment,
what annual rate did she earn?
SOLUTION:

Given data: A = ₱750 P = ₱450

t = 10 n = 1 (assume annually)

Find: r = ?

From: A = P (1 + r/n)nt

750 = 450 (1 + r/1) 1(10)

450 450
𝑟
750 = (1 + )10
1
450

5
= (1 + r)10
3
1
5 10 = 1 + r
( )
3

1.0524 = 1 + r
 1.0524 – 1 = r

r = 0.0524 or 5.24%

Therefore, Mrs. Jefferson earned an annual rate of 5.24%.

SUMMARY:

Compound interest is the interest imposed on a loan or deposit amount. It is the most
used concept in our daily existence. The compound interest for an amount depends on both
Principal and interest gained over periods. This is the main difference between compound
and simple interest.

When calculating compound interest, the number of compounding periods makes a

significant difference. The basic rule is that the higher the number of compounding periods,
the greater the amount of compound interest.

Suppose we observe our bank statements, we generally notice that some interest is
credited to our account every year. This interest varies with each year for the same principal
amount. We can see that interest increases for successive years. Hence, we can conclude
that the interest charged by the bank is not simple interest; this interest is known
as compound interest or CI. In this lesson, we learned what CI is, formula and derivation of
formula to calculate the CI when compounded annually, half-yearly, quarterly, etc.

Also, one can understand why the return on compound interest is more than the return
on simple interest through the examples given based on real-life applications of CI here.

REFERENCES:

Del Rosario, Asuncion (1994) “Mathematics of Investment”.

Versoza, Dhebbie Marie B., (2016). “General Mathematics”, Commission on Higher

Education

https://www.accountingformanagement.org/simple-and-compound-interest/