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
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:
- The future value of a deposit of $8,000 at 16% compounded qua1terly for nine months.
- The future value of a loan of $1,000 for two years at 10% compounded annually.
- The future value of a loan of $2,500 for four years at 8% compounded monthly.
Your Own Notes
- Are there any notes you want to take from this section? Is there anything you’d like to copy and paste below?
- These notes are for you only (they will not be stored anywhere)
- Make sure to download them at the end to use as a reference