Compound Interest
Definition:
Compound interest is interest that is paid not only on the principal but also on any interest earned but not withdrawn during earlier periods.
Compound interest can be calculated using the following formula:
FV = PV (1 + i)
Example 1.3:
John deposits $3,000 in a savings account paying 5 percent interest compounded annually, what is the total amount in his savings account after 2 years?
By using the formula 1.3 and substituting in the variables:
End of first year:
FV = PV (1 + i)
= $3,000(1 + 0.05)
= $3150
End of second year:
²FV = FV (1 + i) = $3,150(1 + 0.05) = $ 3307.5
Hence, $3307.5 is the compound interest earned and the principal sum when $3,000 is invested at 5 percent per annum for 2 years.
However, it would be tedious if interest is calculated using such a long method. Hence, there is a general formula to calculate compound interest. The below formula will combine all 3 steps above that are needed to solve the question:
³FV = PV (1 + i) ³