Compound interest is the addition of interest to the principal sum of a loan or savings account. Basically, it is interest on interest.
Compound interest is interest that is calculated not only on the initial principal, but also the accumulated interest of previous years.
Compound interest is calculated using the formula: F = P( 1 + i)t
You cannot use the formula if:
1) The interest rate, i , changes during the period.
2) Money is added or subtracted during the period.
Final
F = P( Principal
amount Worked example 2
You invested €5 000 at an interest rate of 3% for 2 years. The bank pays you compound interest annually. What is your total return on this investment?
Solution
Remember the BIMDAS order of operations. We must solve the power before we multiply.
Interest rate (expressed as a decimal amount)
1 + i) (initial amount) This formula appears in the formulae and tables booklet. t Always 1
Time (duration)
Remember to use the decimal form for interest rate.
Worked example 3 You borrowed €1 500 for 3 years at 7% interest that is compounded annually (once a year). (i) The entire loan is due to be repaid at the end of the third year. What amount will you repay? (ii) How much interest did you pay?