4.3 Compound Interest Formula

The procedure for adding interest each period can always be used to find the future value of a loan or deposit, but the following general formula gives the future value more directly.

[latex]FV = PV(1+i)^n = PV \left(1+\frac{j_m}{m}\right)^n[/latex]

where:

  • FV = future value of the loan
  • PV = present value of the loan (principal)
  • i = periodic interest rate
  • n = number of compounding periods
Timeline showing Present Value (PV) and Future Value (FV)
Figure 4.1: Cash Flow

 

Example 4.3.1

To see how the formula is developed, consider the $5,000 loan at 8% compounded semi-annually for two years.

First, [latex]i = \frac{0.08}{2}=0.04[/latex]

The balances would be:

At 6 months:

[latex]$5,000(1+0.04) =$5,000(1.04)=$5,200[/latex]

At 1 year:

[latex]$5,200 (1.04)=$5,000(1.04)(1.04) =$5,000 (1.04)^2 = $5,408[/latex]

At 18 months:

[latex]$5,408(1.04)=$5,000(1.04)^2 (1.04) =$5,000(1.04)^3 = $5,624.32[/latex]

At 2 years:

[latex]$5,624.32(1.04)=$5,000(1.04)^3 (1.04) =$5,000(1.04)^4 = $5,849.29[/latex]

This last calculation for the two-year balance is the general formula for FV with:

  • PV = $5,000
  • i = 0.04
  • n = 4 = 2× 2

 

In general, the values for i and n are found by:

[latex]i = \frac{j_m}{m}[/latex]

and

[latex]n = (\text{number of years})\times (\text{number of periods per year})=t\times m[/latex]

 

Knowledge Check 4.2

Use the compound-interest formula to find the following future values:

  1. The future value of a deposit of $8,000 at 16% compounded qua1terly for nine months.
  2. The future value of a loan of $1,000 for two years at 10% compounded annually.
  3. The future value of a loan of $2,500 for four years at 8% compounded monthly.

Solutions at the end of the chapter

 

 

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