Compound Interest

Assume your Investment over 20 years is a high rise building, the ground floor is your Principal (Initial investment) and as each year passes you build an additional floor and at the end of the 20th year you end up having a 50 floor high rise.

Keep up! You will understand.

Compound Interest is the interest you get on not just your initial investment but also on the interest accumulated so far hence, the compound. It is the Initial outlay of investment plus interest reinvested into the investment cycle of compounding returns on investments.

This is why in the above illustration, the number of floors in the building at the 20th year is not 20 but 50 floors i.e. the compounding effect.

How do you calculate the compounding interest on your Investment?

Bernard Invests a NGN 100,000 @ 20%, how much would he realize at the end of 3 years?

ABCD
YearPrincipal (NGN)Interest @20%Balance after 1year (NGN)
0100,000
1100,00020,000120,000
2120,00024,000144,000
3144,00028,800172,800
    

Table 1.1 (D= B+C) (C= B x 20%)

The above table carefully breaks down how Bernard has been able to convert a NGN 100,000 investment into NGN 172,800 in 3 years.  

Now the concept has been well established, the formula used in calculating compound Interest is

FV = PV (1 + r)n                         Where: PV = Present Value

                                                                       r = Interest Rate

                                                                        n = No of Years

                                                                        FV = Future Value 

On some occasions, compounding interest can be paid quarterly, semi-annually, daily or even monthly and the formula only need be adjusted to suit the type of payment. Only two variables are affected to that effect, interest rate (r) and no of years (n), by dividing the annual interest rate by number of payments made (r/m) and multiplying the number of years by the frequency of payment (n x m)

The formula then becomes:

FV = PV (1 + r/m)nm                                   Where: PV = Present Value

                                                                        r = Interest Rate

                                                                        n = No of Years

                                                                        FV = Future Value 

                                                                        M = frequency of payment.

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