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Compound Interest per Year

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Compound Interest per Year

If a person invests $100 in a bank with 6% simple interest, they earn $6 in the first year and $6 again in the second year totaling $112.  If this was really how interest operated with most banks, then someone clever may think to withdraw the $106 after the first year and immediately reinvest it.  That way they earn 6% on $106.  At the end of the second year, the clever person would have earned $6 like normal, plus an extra .36 cents totaling $112.36.  Thirty six cents may seem like not very much, but how much more would a person earn if they saved their $100 for 50 years at 6% compound interest rather than at just 6% simple interest? 

Watch This

http://www.khanacademy.org/finance-economics/core-finance/v/introduction-to-compound-interest

Guidance

Compound interest allows interest to grow on interest.  As with simple interest, PV  is defined as present value, FV  is defined as future value,  i is the interest rate, and t  is time.  The formulas for simple and compound interest look similar, so be careful when reading problems in determining whether the interest rate is simple or compound.  The following table shows the amount of money in an account earning compound interest over time: 

Year

Amount Ending in Account

1

FV=PV(1+i)

2

FV=PV(1+i)^2

3

FV=PV(1+i)^3

4

FV=PV(1+i)^4

 

t

FV=PV(1+i)^t

An account with a present value of PV  that earns compound interest at i  percent annually for t  years has a future value of FV  shown below: 

FV=PV(1+i)^t

Example A

Compute the amount ending in an account for years 1, 2, 3 and 4 for an initial deposit of $100 at 3% compound interest. 

Solution:     PV=100, \ i=0.03, \ t=1,2,3 \ and \ 4, \ FV=?

Year

Amount ending in Account

1

FV=100(1+0.03)=103.00

2

FV=100(1+0.03)^2=106.09

3

FV=100(1+0.03)^3\approx109.27

4

FV=100(1+0.03)^4\approx112.55

Calculator shortcut:  When doing repeated calculations that are just 1.03 times the result of the previous calculation, use the <ANS> button to create an entry that looks like <Ans* 1.03>.  Then, pressing enter repeatedly will rerun the previous entry producing the values on the right. 

Example B

How much will Kyle have in a savings account if he saves $3,000 at 4% compound interest for 10 years? 

Solution:

PV = 3,000, \ i=0.04, \ t=10 \ years, \ FV=?

FV &= PV(1+i)^t\\FV &= 3000(1+0.04)^{10} \approx \$4,440.73

Example C

How long will it take money to double if it is in an account earning 8% compound interest? 

Estimation Solution:   The rule of 72 is an informal means of estimating how long it takes money to double.  It is useful because it is a calculation that can be done mentally that can yield surprisingly accurate results.  This can be very helpful when doing complex problems to check and see if answers are reasonable.  The rule simply states \frac{72}{\mathit{i}}\approx t   where  i is written as an integer (i.e. 8% would just be 8). 

In this case \frac{72}{8}=9\approx t , so it will take about 9 years. 

Exact Solution:   Since there is no initial value you are just looking for some amount to double.  You can choose any amount for the present value and double it to get the future value even though specific numbers are not stated in the problem.  Here you should choose 100 for  PV and 200 for FV

PV = 100, \ FV=200, \ i=0.08, \ t=?

FV &= PV (1+i)^t\\200 &=100(1+0.08)^t\\2 &= 1.08^t\\\ln 2 &= \ln 1.08^t\\\ln 2 &= t \cdot \ln 1.08\\t &= \frac{\ln 2}{\ln 1.08}=9.00646

It will take just over 9 years for money (any amount) to double at 8%.  This is extraordinarily close to your estimation and demonstrates how powerful the Rule of 72 can be in estimation. 

Concept Problem Revisited

Earlier you were introduced to a concept problem contrasting $100 for 50 years at 6% compound interest versus 6% simple.  Now you can calculate how much more powerful compound interest is. 

PV=100, \ t=50, \ i=6\%, \ FV=?

Simple interest:

FV=PV(1+t \cdot i)=100(1+50 \cdot 0.06)=400

Compound interest:

FV=PV(1+i)^t=100(1+0.06)^{50}\approx 1,842.02

It is remarkable that simple interest grows the balance of the account to $400 while compound interest grows it to about $1,842.02.  The additional money comes from interest growing on interest repeatedly. 

Vocabulary

Compound interest is interest that grows not only on principal, but also on previous interest earned. 

The Rule of 72 states that the approximate amount of time that it will take an account earning simple interest to double is t \approx\frac{72}{i} , where i  is written as an integer.

Guided Practice

1.  How much will Phyllis have after 40 years if she invests $20,000 in a savings account that earns 1% compound interest?

2.  How long will it take money to double at 6% compound interest?  Estimate using the rule of 72 and also find the exact answer. 

3.  What compound interest rate is needed to grow $100 to $120 in three years? 

Answers:

1.  t=40, \ PV=20,000, \ i=0.01

FV & =PV(1+i)^t\\& =20,000(1+0.01)^{40}\\& =\$ 29,777.27

2. Estimate:  \frac{72}{6}=12\approx  years it will take to double

PV = 100, \ FV=200, \ i=0.06, \ t=?

     200 &= 100 (1+0.06)^t\\2 &= (1.06)^t\\\ln 2 &= \ln 1.06^t=t \ \ln 1.06\\t &= \frac{\ln 2}{\ln 1.06} \approx 11.89 \ years

3. PV=100, \ FV=120, \ t=3, \ i=?

FV &= PV(1+i)^t\\120 &= 100(1+i)^3\\[1.2]^{\frac{1}{3}} &= [(1+i)^3]^{\frac{1}{3}}\\[1.2]^{\frac{1}{3}} &= 1+i\\i &= 1.2^{\frac{1}{3}}-1 \approx 0.06266

Practice

For problems 1-10, find the missing value in each row using the compound interest formula.

Problem Number

PV FV t i

1.

$1,000

 

7

1.5%

2.

$1,575

$2,250

5

 

3.

$4,500

$5,534.43

 

3%

4.

 

$10,000

12

2%

5.

$1,670

$3,490

10

 

6.

$17,000

$40,000

25

 

7.

$10,000

$17,958.56

 

5%

8.

 

$50,000

30

8%

9.

 

$1,000,000

40

6%

10.

$10,000

 

50

7%

11.  How long will it take money to double at 4% compound interest?  Estimate using the rule of 72 and also find the exact answer. 

12.  How long will it take money to double at 3% compound interest?  Estimate using the rule of 72 and also find the exact answer. 

13.    Suppose you have $5,000 to invest for 10 years.  How much money would you have in 10 years if you earned 4% simple interest? How much money would you have in 10 years if you earned 4% compound interest?

14.  Suppose you invest $4,000 which earns 5% compound interest for the first 12 years and then 8% compound interest for the next 8 years.  How much money will you have after 20 years?

15.  Suppose you invest $10,000 which earns 2% compound interest for the first 8 years and then 5% compound interest for the next 7 years.  How much money will you have after 15 years?

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