Notes on Compound Interest
1. Definition of Compound Interest
Compound Interest (CI) is the interest on a loan or deposit calculated based on both the
initial principal and the accumulated interest from previous periods. This differs from
Simple Interest, which is only calculated on the principal amount.
2. Key Formulas
Compound Interest Formula:
A = P(1 + r/n)^(nt)
Where:
A = the future value of the investment/loan, including interest
P = the principal investment amount (initial deposit or loan amount)
r = the annual interest rate (decimal)
n = the number of times that interest is compounded per year
t = the number of years the money is invested or borrowed.
3. Types of Compounding
- Annually
- Semi-annually
- Quarterly
- Monthly
- Daily
4. Effective Annual Rate (EAR)
Effective Annual Rate (EAR) measures the real return on an investment when compounding
is taken into account.
Formula:
EAR = (1 + r/n)^n - 1
5. Illustrative Examples
Example 1: Compounding Annually
If you invest ₹10,000 at an annual interest rate of 5% for 3 years:
A = 10000 * (1 + 0.05/1)^(1*3)
A = 10000 * (1 + 0.05)^3 = ₹11,576.25
CI = A - P = 11,576.25 - 10,000 = ₹1,576.25
Example 2: Compounding Quarterly
If you invest ₹10,000 at an annual interest rate of 5% compounded quarterly for 3 years:
A = 10000 * (1 + 0.05/4)^(4*3)
A = 10000 * (1 + 0.0125)^(12) = ₹11,576.25
CI = A - P = 11,576.25 - 10,000 = ₹1,576.25
Example 3: Compounding Monthly
If you invest ₹10,000 at an annual interest rate of 5% compounded monthly for 3 years:
A = 10000 * (1 + 0.05/12)^(12*3)
A = 10000 * (1 + 0.0041667)^(36) = ₹11,576.25
CI = A - P = 11,576.25 - 10,000 = ₹1,576.25
6. Common Applications and Tips
1. Use the formula to calculate future investments.
2. Understanding how small differences in the interest rate can lead to large differences in
the amount earned over time.
3. Always consider the effect of compounding when comparing investment options.
