Simple interest and Compounding interest Example

Simple Interest interest paid (earned) only on the original amount, or principal, borrowed money (lent). It is computed like our example above. The formula for that is P x R x T  Where, P = principal, R = rate T = time.
Example: What is the amount of money to be paid out if you deposit 500 pesos today at 5% interest for 5 years?

P = 500 pesos
R = 5%
T = 5 years

Formula: P x R x T
Substitute:  500 x 5% x 5
Answer: 125 pesos Interest earned

Now, after we get the interest earned(125 pesos), we add the principal amount (500 pesos) to get the total sum of money we deposit at the amount of 625 pesos.

Compound Interest when interest paid on an investment,is added to the principal amount, then by the next period  it is the new principal that earned interest on the new sum.Example,What is the amount of money to be paid out if you deposit 500 pesos today at 5% interest compounded for 2 years?

P = 500 pesos
R = 5%
T = 2 years Compounded
 
Formula: P (R x T) c
Substitute:  500 x (5% x 5) 2

Year                    Principal                    Rate                     Interest Earned
 1                           500                           5%                           25.00
 2                           525                           5%                           26.25
                              
 Total money after 2 years is 551.25 pesos

Elaboration: 
P = 500 pesos
R = 5%
T = 2 years Compounded

1st Year
                FV = 500 x 5% x 1 = 25.00 pesos
2nd year
                FV = 525 x 5% x 1 = 26.25 peso

                FV = 525 + 26.25
            
                FV = 551.25

  Note: FV means Future Value.



    Year                     1st            2nd
     500 Deposit ____ |________|
        |                         |                |_____525 php x 2% x 1 yr = 26.25php
        |                         | 

        |                         |_____________ 500 php x 2% x 1 yr = 25.00php
        |
        |____________________________________Deposit  = 500.00 php                                                                                                      
                                                                                   Total  = 551.25 php


In this graph we show how does compound interest work, on the 2nd year we add the interest earn from 1st year automatically to compute the exact interest on the 2nd year.