What is Continuous Compounding?
Continuous Compounding calculates the Limit at which the Compounded interest can reach by constantly compounding for an indefinite period of time thereby increasing the Interest Component and ultimately the portfolio value of the Total Investments
Continuous Compounding Formula
The continuous compounding formulaCompounding FormulaCompounding formula is used to calculate total interest on the principal earned when the interest amount is earned and reinvested. It is calculated by principal amount multiplied by one plus rate of interest raise to the power number of periods less principal amount.read more determines the interest earned, which is repeatedly compounded for an infinite time period.
where,
- P = Principal amount (Present Value)
- t = Time
- r = Interest Rate
The calculation assumes constant compounding over an infinite number of time periods. Since the time period is infinite, the exponent helps in a multiplication of the current investment. This is multiplied by the current rate and time. Despite a large number of investments, a difference in total interest earned through continuous compounding excel is less as compared to traditional compounding, which will be looked into through examples.
Example
Let us analyze some of the instances:
If an initial investment of $1,000 is invested at 8% interest per year with continuous compounding, how much would be in the account after five years?
- P = $1,000, r= 8%, n= 5 years
- FV = P * e ^{rt} = 1,000 * e ^{(0.08) (5) }= 1,000 * e ^{(0.40)} [Exponent of 0.4 is 1.491] = 1,000 * 1.491^{ }
- = $1,491.8
Let us calculate the effects of the same on regular compounding:
Annual Compounding:
- FV = 1,000 * (1 + 0.08) ^ 1 = $1,080
Semi-Annual Compounding:
- FV = 1,000 * [(1 + 0.08/2)] ^ 2
- = 1,000 * (1.04) ^ 2
- = 1,000 * 1.0816 = $1,081.60
Quarterly Compounding:
- FV = 1,000 * [(1 + 0.08/4)] ^ 4
- = 1,000 * (1.02) ^ 4
- = 1,000 * 1.08243
- = $1,082.43
Monthly Compounding:
- FV = 1,000 * [(1 + 0.08/12)] ^ 12
- = 1,000 * (1.006) ^ 4
- = 1,000 * 1.083
- = $1,083
Continuous Compounding:
- FV = 1,000 * e ^{0.08}
- = 1,000 * 1.08328
- = $1,083.29
As can be observed from the above example, the interest earned from continuous compounding is $83.28, which is only $0.28 more than monthly compounding.
Another example can say a Savings Account pays 6% annual interest, compounded continuously. How much must be invested now to have $100,000 in the account 30 years from now?
- FV = PV * e^{rt}
- PV = FV * e – ^{rt}
- PV = 100,000 * e ^{– (0.06) (30)}
- PV = 100,000 * e ^{– (1.80)}
- PV = 100,000 * 0.1652988
- PV = $16,529.89
Thus, if an amount of $16,530 (rounded off) is invested today, it will yield $100,000 after 30 years at the given rate.
Another instance can be if a loan shark charges 80% interest, compounded on a continuous basis, what will be the effective annual interest rate?
- Interest rate = e ^{0.80} – 1
- = 2.2255 – 1 = 1.22.55 = 122.55%
Uses
- Rather than continuous compounding of interest on a monthly, quarterly, or annual basis, this will effectively reinvest gains perpetually.
- The effect allows interest amount to be reinvested, thereby allowing an investor to earn at an exponential rate.
- This determines that it is not only the principal amount that will earn money, but the continuous compounding of interest amount will also keep on multiplying.
Continuous Compounding Calculator
You can use the following Calculator
P | |
r | |
t | |
Continuous Compounding Formula = | |
Continuous Compounding Formula = | P x e^{(r x t)} = | |
0 * e^{(0 * 0) = } | 0 |
Continuous Compounding Formula in Excel (with excel template)
This is very simple. You need to provide the two inputs of Principle Amount, Time, and Interest rate.
You can easily calculate the ratio in the template provided.
Example – 1
You can easily calculate the ratio in the template provided.
Let us calculate the effects of the same on regular compounding:
As can be observed from the continuous compounding example, the interest earned from this compounding is $83.28, which is only $0.28 more than monthly compounding.
Example – 2
Example – 3
Recommended Articles:
This has been a guide to Continuous Compounding formula, its uses along with practical examples. Here we also provide you with Continuous Compounding Calculator with a downloadable excel template. You can refer the following articles as well –
- Compounding Quarterly Formula
- Matrix Multiplication in Excel
- Compound Journal Entry Definition
- Calculate Simple Interest Formula
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