Lecture 6 Simple and Compound Interest

LECTURE ON SIMPLE
AND COMPOUND
INTEREST
When you deposit money in a bank, you permit
the bank to use your money. The bank may lend
the deposited money to customers to buy cars
or make renovations on their homes. The bank
pays you for the privilege of using your money.
The amount paid to you is called interest.
If you are the one borrowing money

from a bank, the amount you pay for
the privilege of using that money is
also called interest.
The amount deposited in a bank or borrowed
from a bank is called the principal.
The amount of interest paid is usually given as a percent

of the principal. The percent used to determine the
amount of interest is called the interest rate.
If you deposit $1000 in a savings account paying

5% interest per year, $1000 is the principal and
the annual interest rate is 5%.
Interest paid on the original principal is called

simple interest.
The simple
interest where I is the
formula is interest, P is
Simple the principal,
Interest
Formula
• I = Prt r is the
interest rate,
and t is the
time period.
When using the simple interest formula,
the time factor, T, must be expressed in
years or a fraction of a year.
In other words, the time t is expressed

in the same period as the rate. If the
rate is given as an annual interest rate, then
the time is measured in years; if the rate is
given as a monthly interest rate, then the
time must be expressed in months.
Interest rates are most commonly
expressed as annual interest rates.
Therefore, unless stated
otherwise, we will assume the
interest rate is an annual interest
rate. Interest rates are generally given
as percents.
Calculating Simple Interest For Loans with
Terms of Days
Exact Number of days of a loan

Interest Time =
365
Exact interest uses365 days as the time

factor denominator. This method is used
by government agencies, the Federal
Reserve Bank, and most credit unions.
Ordinary Number of days of a loan
Interest Time =
360
Ordinary interest uses 360 days as the denominator of the time

factor. This method dates back to the time before electronic
calculators and computers. In the past, when calculating the time
factor manually, a denominator of 360 was easier to use than 365.
Regardless of today’s electronic sophistication, banks and

most other lending institutions still use ordinary interest
because it yields a somewhat higher amount of interest
than does the exact interest method. Over the years,
ordinary interest has become known as the banker’s
rule.
Future Value and Maturity Value
When you borrow money, the total amount to be repaid

to the lender is the sum of the principal and interest. This
sum is calculated using the following future value or
maturity value formula for simple interest.
Future Value or Maturity Value Formula for Simple

Interest
The future or maturity value formula for simple interest is

A= P+I
where A is the amount after the interest, I, has been added to
the principal, P.
For an investment, such as a deposit in a bank savings
account, A is the total amount on deposit after the
interest earned has been added to the principal. This
sum is called the future value of the investment.
We can substitute Prt for I in the future

or maturity value formula, as follows.
• A=P+I
• A = P + Prt
• A = P(1+rt) • Factor P from each term.
In the final equation, A is the future value of an investment

or the maturity value of a loan, P is the principal, r is the
interest rate, and t is the time period.
The formula A =P + I states that A is the amount after
the interest has been added to the principal. Subtracting
P from each side of this equation yields the following
formula.
• I =A – P
This formula states that the amount of interest paid is

equal to the total amount minus the principal.
Exercise
Solve the following word problems. Round to the
nearest cent when necessary.
1. On April 12, Michelle Lizaro borrowed $5,000

from her credit union at 9% for 80 days. The
credit union uses the ordinary interest method.
a. What is the amount of interest on the loan?
Sol.: I = Prt = ($5,000) x (0.09) x (80/360) = $100
b. What is the maturity value of the loan?
Sol.: A = P + I = $5,000 + $100 = $5,100
c. What is the maturity date of the loan?
Sol.: Refer to page 667, the 80 days after April 12 is
July 1st. (July 1st – 182 and April 12 – 102, so subtract
182-102 = 80 days)
2. What is the maturity value of a $60,000 loan for
100 days at 12.2% interest using the exact interest
method? (try to work this)
3. Central Auto Parts borrowed $350,000 at 9%

interest on July 19 for 120 days.
a. If the bank uses the ordinary interest method,
what is the amount of interest on the loan?
b. What is the maturity date? (Try to work this)
Compound Interest
Simple interest is generally used for loans of

1 year or less. For loans of more than 1
year, the interest paid on the money
borrowed is called compound interest.
Compound interest is interest calculated

not only on the original principal, but also
on any interest that has already been
earned.
As this compounding process repeats
itself each period, the principal keeps
growing by the amount of the
previous interest. As the number of
compounding periods increases, the
amount of interest earned grows
dramatically, especially when
compared with simple interest, as
illustrated in Figure 1.
Source: Brechner, R. A. and Bergeman, G. W. (2015). Contemporary Mathematics for Business and Consumers
(Brief Edition), Cengage Learning, USA.
Figure 1: The Time Value of Money

Interest is compounded annually,
semiannually (twice a year), quarterly (four
times a year), monthly, or daily. The frequency
with which the interest is compounded is
called the compounding period.
The calculations necessary to determine

compound interest and compound
amounts can be simplified by using a
formula. Consider an amount P deposited
into an account paying an annual interest
rate r, compounded annually.
The interest earned during the first
year is
I = Prt
I = Pr(1) • t = 1.
I = Pr
The compound amount A in the account after 1
year is the sum of the original principal and the
interest earned during the first year:
A=P +I
A = P + Pr
A = P (1 + r) • Factor P from each term.

During the second year, the interest is
calculated on the compound amount at
the end of the first year, P (1 + r).
I = Prt
I = P (1 + r)r (1) • Replace P with P(1 + r); t = 1.
I = P (1 + r)r
The compound amount A in the account after 2
years is the sum of the compound amount at the
end of the first year and the interest earned during
the second year:
A=P +I
A = P (1 + r) + P (1 + r)r • Replace P with P (1 + r)
and I with P (1 + r)r.
A = 1[P (1 + r)] + [P (1 + r)]r
A = P(1 + r) (1 + r) • Factor P (1 + r) from each
term.
A = P(1 + r)2 • Write (1 + r) (1 + r) as
(1 + r)2.
During the third year, the interest is calculated on
the compound amount at the end of the
second year, P(1 + r)2.
I = Prt
I = P (1 + r)2r (1) • Replace P with P (1 + r)2;
t = 1.
I = P (1 + r)2r
The compound amount A in the account after 3 years
is the sum of the compound amount
at the end of the second year and the interest earned
during the third year:
A =P +I
A = P (1 + r)2 + P (1 + r)2r • Replace P with P (1 + r)2 and I
with P (1 + r)2r.
A = 1[P (1 + r)2] + [P (1 + r)]2r

A = P (1 + r)2 (1 + r) • Factor P (1 + r)2 from each term.
A = P (1 +r)3 • Write (1 + r)2(1 + r) as (1 + r)3.

Note that the compound amount at the
end of each year is the previous year’s
compound amount multiplied by (1 +r ).
The exponent on (1 + r) is equal to the
number of compounding periods.
Generalizing from this, we can state
that the compound amount after n years is
A = P (1 + r)n.
Compound Amount Formula
nt
æ rö
A = P ç1 + ÷
è nø
where A is the compound amount, P is the amount of money
deposited, r is the annual interest rate, n is the number of
compounding periods per year, and t is the number of years.
Recall that compound interest can be compounded
annually (once a year), semiannually (twice a year),
quarterly (four times a year), monthly, or daily. The
possible values of n (the number of compounding
periods per year) are recorded in the table below.
Values of n (Number of compounding Periods per Year)
If interest is
Then n =
compounded
annually 1
semiannually 2
quarterly 4
monthly 12
daily 360
Present Value
The present value of an investment is the

original principal invested, or the value of the
investment before it earns any interest.
Therefore, it is the principal, P, in the
compound amount formula. Present value is
used to determine how much money must
be invested today in order for an investment
to have a specific value at a future date.
Present Value Formula
A
P= nt
æ rö
ç1 + ÷
è nø
where P is the original principal invested, A is
the compound amount, r is the annual interest
rate, n is the number of compounding periods
per year, and t is the number of years.
Inflation
Inflation is an economic condition during which there are increases
in the costs of goods and services. Inflation is expressed as a percent;
for example, we speak of an annual inflation rate of 7%.
To calculate the effects of inflation, we use the same procedure we

used to calculate compound amount.
nt
æ rö
A = P ç1 + ÷
è nø
where A is the compound amount, P is the amount of money
deposited, r is the annual interest rate, n is the number of
compounding periods per year, and t is the number of years.
The Rule of 72
The Rule of 72 states that the number of years for prices to

double is approximately equal to 72 divided by the annual
inflation rate.
72
Years to double =
annual inf lation rate
For example, at an annual inflation rate of 6%, prices will

double in approximately 12 years.
72 72
Years to double = = = 12
annual inf lation rate 6
Effective Interest Rate
When interest is compounded, the

annual rate of interest is called the
nominal rate. The effective rate is the
simple interest rate that would yield the
same amount of interest after 1 year.
When a bank advertises a “7% annual
interest rate compounded daily and
yielding 7.25%,” the nominal interest rate
is 7% and the effective rate is 7.25%.
Exercises
1. Calculate the compound amount when $8000 is

deposited in an account earning 8% interest,
compounded quarterly, for 5 years.
Sol: A = $8000 (1+ 0.08/4) ^(4 x 5) = $11, 887.58
2. Calculate the compound amount when $3000 is

deposited in an account earning 10% interest,
compounded semiannually, for 3 years.
3. If you leave $2500 in an account earning 9%
interest, compounded daily, how much money
will be in the account after 4 years?
THANK YOU AND
GOD BLESS!

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LECTURE ON SIMPLE

If you are the one borrowing money

The amount of interest paid is usually given as a percent

If you deposit $1000 in a savings account paying

Interest paid on the original principal is called

In other words, the time t is expressed

Exact Number of days of a loan

Exact interest uses365 days as the time

Ordinary interest uses 360 days as the denominator of the time

Regardless of today’s electronic sophistication, banks and

When you borrow money, the total amount to be repaid

Future Value or Maturity Value Formula for Simple

The future or maturity value formula for simple interest is

We can substitute Prt for I in the future

In the final equation, A is the future value of an investment

This formula states that the amount of interest paid is

1. On April 12, Michelle Lizaro borrowed $5,000

3. Central Auto Parts borrowed $350,000 at 9%

Simple interest is generally used for loans of

Compound interest is interest calculated

Figure 1: The Time Value of Money

The calculations necessary to determine

A = P (1 + r) • Factor P from each term.

I = P (1 + r)r (1) • Replace P with P(1 + r); t = 1.

A = 1[P (1 + r)2] + [P (1 + r)]2r

A = P (1 +r)3 • Write (1 + r)2(1 + r) as (1 + r)3.

Values of n (Number of compounding Periods per Year)

The present value of an investment is the

To calculate the effects of inflation, we use the same procedure we

The Rule of 72 states that the number of years for prices to

For example, at an annual inflation rate of 6%, prices will

When interest is compounded, the

1. Calculate the compound amount when $8000 is

2. Calculate the compound amount when $3000 is

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