Are these both compound interest formulae

finance

Given $i$ the annual interest rate expressed as a decimal, $P$ the principle value and $F$ the future value.

If I want to compound my interest $n$ times per year for $t$ years what is the difference between the following two methods ?

$$F=P(1+\frac{i}{n})^{nt}$$

$$F=P(1+r)^{nt}\ ,\ \textrm{where}\ (1+r)^n=(1+i)$$

My understanding is that the second formula is not compounding n times per year.

Wikipedia give the first formula as the compound interest formula.

My high school textbook gives the $2$nd method for compound interest but I feel it expresses something different.

When would one use both these formulae ?

Best Answer

They are in fact different formulas and will generally yield different answers for the same values of $i$, $n$, $t$, and $P$.

The first formula gives the future or accumulated value of an investment of $P$ for a term of $t$ years, where the compounding occurs $n$ times per year, for a nominal annual rate of interest $i$.

The second formula gives the accumulated value of the same investment for the same term, but in this case, $i$ is an effective annual rate of interest. In this formula, the frequency of compounding is irrelevant, since substituting $(1+r)^n = 1+i$ yields $$F = P(1+i)^t,$$ which shows the accumulated value does not depend on $n$.

What does "nominal" and "effective" mean in this context? An effective rate of interest is one that specifies the amount of change in the investment over a given time period (usually but not always one year), in such a way that it does not matter what the compounding structure looks like within the period. So if I say $6\%$ effective annual interest rate, that means if I have $100$ in principal at the beginning of the term, then at the end of one year, I will have $106$, no matter whether the investment is being compounded quarterly, monthly, daily, or hourly. The commonly-known and used terminology for effective annual interest is "APY," or "Annual Percent Yield."

As convenient as effective interest may be to understand, it naturally leads to some questions: for instance, in many cases, the owner of such an investment might not hold it for an exact number of years. Or in the case of a loan, the borrower may need to repay the loan on a monthly basis. In such situations, it is of interest to know what is the balance on the investment or loan at some intermediate point within the annual period.

So, one way we can also specify how interest is accrued is to state a "nominal" rate, one that takes into account the frequency of compounding. For instance, if I say that a loan has a nominal annual interest rate of $6\%$, compounded monthly, that means that the effective monthly interest rate is $0.06/12 = 0.005 = 0.5\%$ per month, and on a principal of $100$, the loan balance would be $100.5$ after one month. After 12 months, the loan balance (assuming no repayments) would be $100(1.005)^{12} \approx 106.168$.

As you can see, in this case, the nominal annual rate, $6\%$, is slightly lower than the corresponding effective annual rate, which is $6.168\%$. The commonly-known and used terminology for nominal annual interest is "APR," or "Annual Percentage Rate."

Which one do we use? Simply put, you can use either one--typically, whichever is more convenient--as long as you are clear about which interest rate you are specifying. As we saw in the previous example, $6\%$ nominal interest compounded monthly is equal to $6.168\%$ effective annual interest.

In actuarial practice, we use $i$ to denote effective interest, and the symbol $i^{(m)}$ for nominal interest compounded $m$ times per period (usually a year). Therefore, the relationship between these two rates is $$\left(1 + \frac{i^{(m)}}{m} \right)^m = 1 + i.$$

Related Question