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Compound Interest: Periodic Compounding

You may like to read about Compound Interest first.
You
can skip straight down to Periodic Compounding.

Quick Explanation of Compound Interest

With Compound Interest, you work out the interest for the first period, add it to the total, and then calculate the interest for the next period, and so on ..., like this:


But adding 10% interest is the same as multiplying by 1.10

(explained here)

So it also works like this:


In fact we can go from the Start to Year 5 if we multiply 5 times using Exponents (or Powers):

The Formula

We have been using a real example, but let's be more general by using letters instead of numbers, like this:

Examples

So $1,000 invested at 10% for 5 Years would become:

... and what if the interest rate was only 6%?

Periodic Compounding (Within The Year)

But sometimes interest is charged Yearly ...

... with several compoundings within the Year.

Compoundings Within The Year

Let's see what happens if there are two compoundings per year

Example: "10%, Compounded Semiannually"

Semiannual means twice a year. So the 10% is split into two:

  • 5% halfway through the year,
  • and another 5% at the end of the year,

but each time it is compounded (meaning the interest is added to the total):

10%, Compounded Semiannually

This results in $1,102.50, which is equal to 10.25%, not 10%

Two Annual Interest Rates?

Yes, there are two annual interest rates:

  Example  
  10% The Nominal Rate (the rate they mention)
     
  10.25% The Effective Annual Rate (the rate after compounding)
     
  The Effective Annual Rate is what actually gets paid!

If interest is compounded within the year, the Effective Annual Rate rate will be higher than the rate mentioned.

How much higher depends on the interest rate, and how many times it is compounded within the year.

Working It Out

Let's come up with a formula to work out the Effective Annual Rate if we know:

  • the rate mentioned (the Nominal Rate, "r")
  • how many times it is compounded ("n").

Our task is to take an interest rate (like 10%) and chop it up into "n" periods, compounding each time.

From the Compound Interest formula, above, we can compound "n" periods using

FV = PV (1+r)n

But the interest rate won't be "r", because it has to be chopped into "n" periods like this:

r / n

So we change the compounding formula into:

FV = PV (1+(r/n))n

Let's try it on our "10%, Compounded Semiannually" example:

FV = $1,000 (1+(0.10/2))2 = $1,000(1.05)2 = $1,000 × 1.1025 = $1,102.50

That worked! But we want to know what the new interest rate is, we don't want the dollar values in there, so let's remove them:

(1+(r/n))n = (1.05)2 = 1.1025

That has the interest rate in there (0.1025 = 10.25%), but we should subtract the extra 1:

(1+(r/n))n -1 = 0.1025 = 10.25%

And so the formula is:

Effective Annual Rate = (1+(r/n))n -1


Example: what rate would you get if the ad says "6% compounded monthly"?

Effective Annual Rate = (1+(r/n))n -1 = (1+(0.06/12))12 -1 = (1.005)12 -1 = 0.06168 = 6.168%

So you would actually get 6.168%

So remember:

Chop the interest rate into "n" periods r / n
   
Compound that "n" times: (1+(r/n))n
   
Don't forget to subtract the "1" (1+(r/n))n - 1

 

Table of Values

Here are some example values. Notice that compounding has a very small effect when the interest rate is small, but a large effect for high interest rates.

Compounding Periods 1.00% 5.00% 10.00% 20.00% 100.00%
Yearly 1 1.00% 5.00% 10.00% 20.00% 100.00%
Semiannually 2 1.00% 5.06% 10.25% 21.00% 125.00%
Quarterly 4 1.00% 5.09% 10.38% 21.55% 144.14%
Monthly 12 1.00% 5.12% 10.47% 21.94% 161.30%
Daily 365 1.01% 5.13% 10.52% 22.13% 171.46%
Continuously Infinite 1.01% 5.13% 10.52% 22.14% 171.83%

Continuously?

Yes, if you have smaller and smaller periods (hourly, minutely, etc) you eventually reach a limit, and we even have a formula for it:

Continuous Compounding Formula
Note: e=2.71828..., Euler's number.

Example, Continuous Compounding for 20% is: e0.20 - 1 = 1.2214... - 1 = 0.2214...

Conclusion

 

Effective Annual Rate = (1+(r/n))n -1
 

Where:

  • r = Nominal Rate (the rate they mention)
  • n = number of periods that are compounded (example: monthly=12)