What is simple interests and interest compounding? Full explanations with examples and easy to use online calculators to experiment with different values of the parameters involved in order to understand the different formulas related to interests compounding are presented. Problems on Compound interests with detailed solutions are also included in this site.
In order to understand compounding, you need to first understand the percentage increase of a quantity.
If P is a quantity that is increased by a percentage rate r, then the new quantity is P + r P
You need to retain the above:
A quantity P increased by a percentage rate r becomes P + r P = P ( 1 + r)
Example 1: 200 increased by 5% becomes
I = P r t
A = P + P r t = P(1 + r t)
A = P(1 + r) t
So if an amount P (principal) is invested at the annual rate r and is compounded annually, the total amount A at the end of t years is given byA = P(1 + r) t
Example 2: $1000 is invested for 3 years, compounded every year, at the rate of 3%. The amount A (rounded to the nearest cent) at the end of 3 years is shown on the calculator below.(click on Enter)
A = P(1 + r) t = 1000(1 + 0.03) 3 = $1092.73
You may use the calculator to input and experiment with more values for P, r and t and obtain the amount A. Use your own calculator and compare the results.
A = P(1 + r/n) n t
Example 3: $1000 is invested for 3 years, compounded twice a year (n = 2), at the rate of 3%. The amount A (rounded to the nearest cent) at the end of 3 years is shown on the calculator below.(click on Enter)
A = P(1 + r/n) n t = 1000(1 + 0.03 / 2) 2×3 = $1093.44
You may use the calculator to input and experiment with more values for P, r, t and n and obtain the amount A. Use your own calculator and compare the results.
To understand the advantage of Compounding more than once a year, Keep P, r and t constant (The same amount invested at the rate r for t years) and increase n. What happens to A?
As the number of compounding n increases, N also increases, the term (1 + 1 / N) N approaches a constant value which is called e and is approximately equal 2.718282... . More rigorously, e is defined as the limit of (1 + 1/N) N as N approaches infinity.
Hence for continuous compounding (n very large) at the rate r and an initial amount P and after t years A is given by:
A = P e r t
Example 4: $1000 is invested for 3 years, compounded continuously, at the rate of 3%. The amount A (rounded to the nearest cent) at the end of 3 years is shown on the calculator below.(click on Enter)
A = P e r t = 1000 e 0.03 × 3 = $1094.17
You may use the calculator to input and experiment with more values for P, r, and obtain the amount A. Use your own calculator and compare the results.
Conclusion: compare the way the same amount of $1000 was compounded in the eaxamples 1,2 and 4 and make a conclusion as to which compounding earns more.