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The Mathematics of Compound Interest

MATHEMATICS

Rationale

This is an exploration into the mathematics of compound interest and its application in retirement
saving.

Motivation to area of research

Aim

The aim of the exploration is to explore, through the use of

Scope

Research question

What factors affect the retirement savings

Tools used
1. Excel by Microsoft.
2. GDC TI-84 Plus by Texas Instruments
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Background concepts of the mathematics used

“Interest on interest” in the simplest form is based on having an initial sum of money saved in an
account for a number of years. The interest received is reinvested into the account, hence the
expression “interest on interest”.

r nt
The formula !A = C(1 + ) , can be used to calculate interest, where A is the final amount (capital +
n
interest), C is capital, r is the interest rate expressed as a decimal, n is the number of compoundings in a
year and t is the number of years.

For a more effective analysis of the formula, a few assumptions can be made about the possible values
the different variables can adopt. C and t cannot take on negative values as the initial instalment and the
number of years always are positive; C ! = | x | and !t = | y | . The interest, r, presumably ranges between
1 and 8 percent; !0.01 ≥ r ≤ 0.08. Furthermore, interest is usually accrued once a year,! ∴ n = 1. We can
therefore neglect the variable n in the formula: A! = C(1 + r)t, and, hence, interpret a few different
trends from different graphs produced by the formula.

The rate of interest has a crucial effect on final amount of money saved, as the interest is added to the
saved sum. Therefore also the number of years have the same strong effect on the final sum of money.

Let us assume that a wage earner Mohammed is a 25 years old Computer Science student will have a
final yearly salary of 900 000 SEK (75 000 SEK/Month) plans to retire at age 65. The Swedish life
expectancy is 82 years in males. As a pensioner he wants to continue to live with the same standard as
he did in his final years of employment.

According to Pensionsmyndigheten, Mohammed would receive 40-50% of his final yearly salary when
he retires. Therefore Mohammed needs to save to cover for a yearly salary of 450000 SEK (37500
SEK/Month) for 17 years (82-65).

The final amount of the retirement fund could be calculated according to the following formula:
!A = 0.6 ⋅ sa l ar y ⋅ ( pen sion years) ⋅ 12

Hence, Mohammed needs to save 450 000 SEK (37500 SEK/Month), and the number of expected
pension years are 17 as the Swedish life expectancy is 82 years.
Using these numbers in the formula:

A= 450 000 · 17
A= 7 650 000 SEK

Mohammed needs to have a retirement fund of 7 650 000 SEK when he reaches 65 years. Clearly, a
number of assumptions have been made to reach this figure. We have not included inflation or the
usual increase in salary over the years. Nor have we included any changes in the retirement fund payed
by the government. Also, we don’t expect any interest on the money saved after the age of 65. Usually
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the money sits on a low interest account after the age of 65 to make sure it is not lost to changes on the
stock market for example.

There are different ways of reaching this saving. For example have a large sum of money to save early
or to save a fixed amount every month.

A third way would be to to change the age of retirement as the savings fund is increasing exponentially
which can be shown by derivative of the savings formulae.

A=C(1+r)t

A’ indicates the derivate of the savings graph, that is the yearly increase of the money in the savings
account. As the graph is exponential the A’ increases each year, see table beside figure 1.

A’=tC(1+r)t-1C’(1+r)

With A= 7 650 000 SEK

t= 40 (from the age of 25 to retirement at 65 years)
r= 0.08 (8%)
C needs to be 352 137 SEK, that means that Mohammed needs to put in 352 137 SEK at the age of 25
to be able to reach a retirement fund of 7 650 000 SEK at the age of 65, (see figure 1 below).

If Mohammed decided to work 3 more years he would only need to save 450 000· 14 = 6 300 000 SEK
as he is only expected to live 14 years from the age of 68, and at the same time he would gain 3 more
years of interest on his money.

By using the formula

C= A/(1+r)t we can deduce the inital installment Mohammed needs to make to reach 6 300 000 SEK
at the age of 68.

6 300 000/(1+0.08)43=230 207 SEK

3 things happened when he decided to work for 3 additional years,

1) He could reduce his primary saving by 121 930 SEK
2) He only needs to save 6 300 000 SEK ( 1 350 000 SEK less than initially)
3) 3 more years of interest gave him 1 298 855 SEK using the new primary saving of 230 207
SEK (see graph 2).
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Years Value (kr=SEK) Increase/year
8 250 000 kr
0 352 137 kr 0 8 000 000 kr
1 380 308 kr 28 171 7 750 000 kr
2 410 733 kr 30 425 7 500 000 kr
3 443 591 kr 32 859 7 250 000 kr
7 000 000 kr
4 479 079 kr 35 487
6 750 000 kr
5 517 405 kr 38 326 6 500 000 kr
6 558 797 kr 41 392 6 250 000 kr
7 603 501 kr 44 704 6 000 000 kr
8 651 781 kr 48 280 5 750 000 kr
5 500 000 kr
9 703 923 kr 52 142
5 250 000 kr
10 760 237 kr 56 314 5 000 000 kr
11 821 056 kr 60 819 4 750 000 kr

ENDVALUE (SEK)
12 886 741 kr 65 685 4 500 000 kr
13 957 680 kr 70 939 4 250 000 kr
4 000 000 kr
14 1 034 295 kr 76 614
3 750 000 kr
15 1 117 038 kr 82 744 3 500 000 kr
16 1 206 401 kr 89 363 3 250 000 kr
17 1 302 913 kr 96 512 3 000 000 kr
18 1 407 146 kr 104 233 2 750 000 kr
2 500 000 kr
19 1 519 718 kr 112 572
2 250 000 kr
20 1 641 295 kr 121 577 2 000 000 kr
21 1 772 599 kr 131 304 1 750 000 kr
22 1 914 407 kr 141 808 1 500 000 kr
23 2 067 560 kr 153 153 1 250 000 kr
1 000 000 kr
24 2 232 964 kr 165 405
750 000 kr
25 2 411 602 kr 178 637 500 000 kr
26 2 604 530 kr 192 928 250 000 kr
27 2 812 892 kr 208 362 0 kr
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40
28 3 037 923 kr 225 031
NUMBEROFYEARS
29 3 280 957 kr 243 034
30 3 543 434 kr 262 477
31 3 826 909 kr 283 475
32 4 133 061 kr 306 153
33 4 463 706 kr 330 645
34 4 820 803 kr 357 096
35 5 206 467 kr 385 664
36 5 622 984 kr 416 517
37 6 072 823 kr 449 839
38 6 558 649 kr 485 826
39 7 083 341 kr 524 692
40 7 650 008 kr 566 667

Fig 1. The graph is showing the increase in the value of Mohammeds savings if he at the age of 25
saved 352 137 SEK. From the graph and the table to the left it is obvious that the increase in the
savings is faster for each year, showing that the graph is exponential and for each extra year of work
before retirement the gain would be larger.

Years Value (kr=SEK) Increase/year

6 750 000 kr
0 230 207 kr 0
6 500 000 kr
1 248 624 kr 18 417
6 250 000 kr
2 268 513 kr 19 890
6 000 000 kr
3 289 995 kr 21 481
5 750 000 kr
4 313 194 kr 23 200
5 500 000 kr
5 338 250 kr 25 056
5 250 000 kr
6 365 310 kr 27 060
5 000 000 kr
7 394 534 kr 29 225
4 750 000 kr
8 426 097 kr 31 563
4 500 000 kr
9 460 185 kr 34 088
4 250 000 kr
10 497 000 kr 36 815
4 000 000 kr
11 536 760 kr 39 760
ENDVALUE (SEK)

3 750 000 kr
12 579 700 kr 42 941
13 626 076 kr 46 376 3 500 000 kr

14 676 163 kr 50 086 3 250 000 kr

15 730 256 kr 54 093 3 000 000 kr

16 788 676 kr 58 420 2 750 000 kr

17 851 770 kr 63 094 2 500 000 kr

18 919 912 kr 68 142 2 250 000 kr

19 993 505 kr 73 593 2 000 000 kr
20 1 072 985 kr 79 480 1 750 000 kr
21 1 158 824 kr 85 839 1 500 000 kr
22 1 251 530 kr 92 706 1 250 000 kr
23 1 351 652 kr 100 122 1 000 000 kr
24 1 459 784 kr 108 132 750 000 kr
25 1 576 567 kr 116 783 500 000 kr
26 1 702 692 kr 126 125 250 000 kr
27 1 838 908 kr 136 215 0 kr
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43
28 1 986 020 kr 147 113
NUMBEROFYEARS
29 2 144 902 kr 158 882
30 2 316 494 kr 171 592
31 2 501 814 kr 185 320
32 2 701 959 kr 200 145
33 2 918 115 kr 216 157
34 3 151 565 kr 233 449
35 3 403 690 kr 252 125
36 3 675 985 kr 272 295
37 3 970 064 kr 294 079
38 4 287 669 kr 317 605
39 4 630 682 kr 343 014
40 5 001 137 kr 370 455
41 5401227,874 400 091
42 5 833 326 kr 432 098
43 6 299 992 kr 466 666

Figure 2. By adding 3 years of work the initial saving could be reduced to 230 207 and he only needed
to reach 6 300 000 SEK.
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Calculations

So with an initial saving of 100 000 Swedish crowns (SEK) and an interest of 8% (if placed on the
stock market) and kept for 45, 30 or 20 years I would have 3 192 045, 1 066 266 resp. 466 096 SEK.

In this case a deposit into the savings account would be made every month, and the interest would be
compounded yearly.

First I decided to see how large my end savings would be if you saved 1000 SEK/month and started at
the age of 25, 40 and 50 years. The savings would be almost 10 times larger if you started at the age of
25 to the age of 50 years.
Then I decided to see how much you had to save to reach 5 million Swedish crowns (SEK) by the age
of 70 if you started when you are 25, 40 or 50 years of age and therefore save for 45, 30 or 20 years. I
was also initially optimistic in getting an interest of 8% each year in interest. It is obvious from the
amount that I would have to save/month is much higher if I start at an older age.
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Conclusion and reflection

This exploration should give a clear idea of what factors affect saving for retirement and what
strategies can be used to add up to a sizeable retirement account in the Swedish pension system.
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References
https://www.wolframalpha.com/

https://rikatillsammans.se/verktyg/kalkylator-rakna-pa-ranta-pa-ranta/

https://www.pensionsmyndigheten.se/