## Compounding

Calculating Compound Interest on a Basis Other than Annually: correctly

As with the previous page time is against me and I have prepared this post as a PDF file. The link is below. This is what the page is about and there is an Excel file to download too, link also below!

Introduction

In the course of a discussion in the Financial Modelling in Excel Group on LinkedIn I found what I considered to be an error in a spreadsheet and offered my solution. I was told the source of the error was due to the gentleman concerned not being an accountant or financial anything and he had copied it from another modeller. I accepted the reason for that since it turned out to be true!

There was then another rejoinder from another non financial contributor who not only said that there are different solutions depending on whether one is in the EU or the US but that in the USA the result is found by using simple interest methods. The suggestion is that APR (Annual Percentage Rate) in the EU is found by compounding and in the US they use simple interest.

Summary

The correct formula for compounding, for example, on a monthly basis is to divide the rate of interest by 12 in the compound interest factor and then raise the factor to the power of the number of months, m … see the PDF file for the formula

It is incorrect not to divide the interest rate and then raise the compound factor by m/12 where m is the number of months: … see the PDF file for the formula

Simple interest is not appropriate for this discussion and can be ignored except that I have explained what it is and the differences between compound interest and simple interest: see the next section.