Interest
For annual interest with rate r the interest on P dollars left for
one year is rP. Thus, P1 = P0 + rP0 .
Interest
For annual interest with rate r the interest on P dollars left for
one year is rP. Thus, P1 = P0 + rP0 .
For the next year the interest is rP1 and so
P2 = P1 + rP1 = P0 + rP0 + rP0 + r 2 P0 .
Let us pause here to look at a little puzzle.
Suppose you buy something with price P, but there is a 6%
tax. You must pay P + .06P. Suppose you are given a 10%
discount. Then you would pay P − .1P. Now the question:
Which way would you do better?
I Take the discount first and then add the tax on the
smaller amount, or
I Add the tax first and then take the discount on the whole
thing, tax and all.
The answer is that the results are the same.
For the tax, instead of thinking of adding .06P to P,think that
you are adding 6% to 100% for a total of 106%. That is, you
are multiplying by 1.06.
For the discount, you are subtracting 10% from 100% and so
are paying 90% of the original price. That is, you are
multiplying by .9.
So the two options are: First multiply P by .9 and then
multiply by 1.06, or, alternatively first multiply by 1.06 and
then by .9.
The results are the same.
Back to the interest computation:
We had P2 = P1 + rP1 = P0 + rP0 + rP0 + r 2 P0 .
But notice that P + rP = (1 + r )P. So each year we multiply
by (1 + r ).
Beginning with P0 we have Pt = (1 + r )t P0 .
The units of the interest rate r are dollars of interest per dollar
of principal per year. So in a fraction 1/n of a year, the
interest on P is (r /n)P.
So if you compound semi-annually, you multiply by (1 + 2r )
every half year.
2
The principal after one year is (1 + 2r )2 P = (1 + r + r4 )P. The
extra bit is the interest on the previous six month’s interest.
r
So if you compound every month, you multiply by (1 + 12 )
r 12
every month. So the principal after one year is (1 + 12 ) P.
So compound interest with n periods per year yields Pt , after t
years, given by
r 1
Pt = (1 + )nt P0 = ((1 + h) h )rt P0
n
r
where h = n
so that nt = rth .
So compound interest with n periods per year yields Pt , after t
years, given by
r 1
Pt = (1 + )nt = ((1 + h) h )rt
n
r rt
where h = n
so that nt = h .
For continuous compounding we take the limit as n tends to
infinity or, equivalently, as h tends to zero. To recall what
happens to the limit, write
1
ln((1 + h) h ) = ln(1+h)−ln(1)
h
whose limit is the derivative of
ln(x) at x = 1 and so is 1.
1
Hence, limh→0 (1 + h) h = e 1 = e, and with continuous
compounding
Pt = P0 e rt .
The equation Pt = P0 e rt is exactly exponential growth with
rate r . This is also derived as follows
The change in the principal due to interest is dP = rPdt,
which is exponential growth with rate r .
The problems also feature a constant flow of k dollars per year
with k > 0, eg for money put into a bank account, or with
k < 0 for money paying off a loan. So the combined effect is
dP = (rP + k)dt.