The Mathematics of Finance

SIMPLE AND COMPOUND INTEREST

 Simple Interest
Definition of Terms
Interest
The monetary charge for the privilege of borrowing money, typically expressed as an annual
percentage rate (APR).
The amount of money a lender or financial institution receives for lending out money.
interest rate
Principal
The amount deposited in a bank or borrowed from a bank

Interest rate
The percent used to determine the amount of interest

Simple interest
Interest paid on the original principal
 Simple Interest

NOTE:

𝑻𝒊𝒎𝒆 𝒕 = expressed in the same period as the rate

𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒓𝒂𝒕𝒆𝒔 𝒓 = most commonly expressed as annual interest rates. Therefore, unless
stated otherwise, we will assume the interest rate is an annual interest rate
 Simple Interest
If the time period of a loan with an annual interest rate is given in days:
• Ordinary method
Based on there being an average of 30 days in a month and 12 months in a year (30 𝑥 12) = 360.

used by most businesses

• Exact method
Based on a period that includes all 365 days of the year or 366 days for a leap year.

Note: A year is a leap year if it is divisible by 4 except when it is divisible by 100 but not by 400
Example:
2024 2029 2032
2012 2000 3000
 Simple Interest
Example: Calculate the simple interest earned in 1 Example: Calculate the simple interest due on
year on a deposit of $1000 if the interest rate is 5%. a 3-month loan of $2000 if the interest rate is
6.5%.

Solution: Solution:
 Simple Interest
Example: Calculate the simple interest due on a 2- Example: Calculate the simple interest due on a
month loan of $500 if the interest rate is 1.5% per 45-day loan of $3500 if the annual interest rate is 8%.
month.

Solution: Solution:
 Simple Interest
Example: The simple interest charged on a 6-month
loan of $3000 is $150. Find the simple interest rate.

Solution:
 Simple Interest
Future Value and Maturity Value

NOTE:
𝐴 = 𝑃 + 𝑃𝑟𝑡
𝑨 = 𝑷(𝟏 + 𝒓𝒕)

• Loan
𝐴 is the total amount to be repaid to the lender; this sum is called the maturity value of
the loan.
• Investment
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.
 Simple Interest
Example: Calculate the maturity value of a simple Example: Calculate the maturity value of a
interest, 8-month loan of $8000 if the interest rate simple interest, 3-month loan of $3800. The interest
is 9.75%. rate is 6%.

Solution: Solution:
 Simple Interest
Example: Find the future value after 1 year of $850 Example: The maturity value of a 3-month loan
in an account earning 8.2% simple interest. of $4000 is $4085. What is the simple interest rate?

Solution: Solution:
 Compound Interest
Compound Interest
Interest calculated not only on the original principal, but also on any interest that has already been
earned.
Compound Interest
Example: Calculate the compound amount when
$10,000 is deposited in an account earning 8%
interest, compounded semiannually, for 4 years.

Solution:
 Simple Interest
Example: Calculate the future value of $5000 Example: How much interest is earned in 2 years
earning 9% interest, compounded daily, for 3 years. on $4000 deposited in an account paying 6%
interest, compounded quarterly?

Solution: Solution:
 Compound Interest
Present Value
Used to determine how much money must be invested today in order for an investment to have a
specific value at a future date.
 Compound Interest
Example: How much money should be invested in
an account that earns 8% interest, compounded
quarterly, in order to have $30,000 in 5 years?

Solution:
 Compound Interest
Inflation
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%.
 Compound Interest
Example: A credit union offers a certificate of deposit Example: One bank advertises an interest rate
at an annual interest rate of 3%, compounded of 5.5%, compounded quarterly, on a certificate of
monthly. Find the effective rate. Round to the nearest deposit. Another bank advertises an interest rate of
hundredth of a percent. 5.25%, compounded monthly. Which investment
has the higher annual yield?

Solution: Solution:
Compound Interest
 Compound Interest
Effective Interest Rate
The simple interest rate that would yield the same amount of interest after 1 year.

Nominal Interest Rate

The annual rate of interest when interest is compounded.

Effective Interest Rate

“7% annual interest rate compounded daily and yielding 7.25%,”

Nominal Interest Rate

 Compound Interest
Example: Suppose your annual salary today is Example: Suppose you purchase an insurance policy
$35,000. You want to know what an equivalent in 2015 that will provide you with $250,000 when
salary will be in 20 years—that is, a salary that will you retire in 2050. Assuming an annual infl ation
have the same purchasing power. Assume a 6% rate of 8%, what will be the purchasing power of the
inflation rate. $250,000 in 2050?

Solution: Solution: