TOPIC 1: Simple and Compound interest

Estimated Time: 3 hours

Topic Outcomes:
At the end of the topic, you are expected to:
1. Know and use of simple and compound interest terminology
2. Understand when interest is paid and earned
3. Formulate the use of formula for calculating the total amount of a loan or total value of an investment at the end
of a specific term
4. Understand how to algebraically manipulated the interest formulas to solve different variables

Topic Contents:
The Time Value of Money (TVM) is the idea that money available at the present time is worth more than the
same amount in the future due to its potential earning capacity. This important concept in financial management because
it can be used to compare investment alternatives and to solve problems involving loans, leases, and savings.
From the viewpoint of the borrower, interest is the amount of money paid for the use of borrowed capital. For
the lender, interest is the income produced by the money which he has lent.
The charging of interest is justified, from the standpoint of the lender, because he has to forego the use of his
money during the time it is borrowed and to compensate him also for the risk that he has to take in lending his money.
From the borrower’s viewpoint, it is usually advantageous to borrow money if in so doing he will be able to earn more than
the interest which he has to pay.

2.1 SIMPLE INTEREST

Simple Interest (denoted as I) is defined as the interest on a loan or principal that is based only on the original
amount of the loan or principal. The interest to be paid is directly proportional to the length of time the amount or
principal is borrowed. The principal amount of money borrowed and on which interest is charged. The rate of interest is
the amount earned by one unit of principal during a unit of time.
This means that the interest charges grow in linear function over a period of time. This is usually used for short-
term loans where the period of the loan is measured in days rather than years. It can be calculated using the following
formula.
I =Pin
Where: I = total interest earned by the principal
P = amount of principal
I = rate of interest per period expressed in decimal form
n =number of interest periods

The total amount F to be repaid is equal to the sum of the principal and the total interest and is given by the
formula:
F=P+ I F=P+ Pin F=P(1+¿)

where: F = future amount

P = principal
I = interest per period
N = number of periods

2.2 TYPES OF SIMPLE INTEREST

a. Ordinary Simple Interest- is based on one banker’s year. A banker year is composed of 12 months of 30
days each which is equivalent to a total of 360 days in a year. The value of n that is used in the preceding
formulas may be calculated as 1 banker’s year= 12 months, each consisting of 30 days= 360 days.

d where, d= number of days

n=
360

b. Exact Simple Interest- is based on the exact number of days in a given year. An ordinary or normal year has
365 days while a leap year (which occurs once every 4 years) has 366 days. The leap years are those which
are exactly divisible by 4, but excluding the century years (ending with two zeroes like 1900, 2000, etc.) must
be divisible by 400

For normal years: d For leap years: d

n= n=
365 366
where, d= number of days
Sample Problems:
1. Determine the ordinary simple interest on ₱10,000 for 9 months and 10 days if the interest is 12%.

2. Determine the ordinary and exact simple interests on ₱5,000 for the period from January 15 to June 20, 1993,
if the rate of simple interest is 14%.

3. Determine the exact and ordinary simple interests on ₱1,200 for the period from January 16 to November 26,
1992, if the rate of interest is 24%.

4. A man borrows ₱10,000 from a loan firm. The rate of simple interest is 15% but the interest is to be deducted
from the loan at the time the money is borrowed. At the end of one year, he has to pay back ₱10,000. What is
the actual rate of interest?

5. Determine whether the years 1982, 1996, 1800, or 2000 are leap years or just ordinary years.

6. Find the total amount on ₱10,500 invested at 5% for 75 days using exact interest.

7. A loan of ₱5,000 is made for a period of 15 months, at a simple interest rate of 15%, what future is due at the
end of the loan period?

8. In how many years will the simple interest on ₱3,500 at the rate of 9% per annum be the same as simple
interest ₱4,000 at 10.5% per annum for 4 years?

9. Find the principal if it earns ₱300 interest when invested for 120 days at 4.5% simple interest.

10. A loan of ₱4,000 is made for a period of 16 months at a simple interest rate of 7%, what future amount is due
at the end of the loan period?

2.3 COMPOUND INTEREST

Compound Interest, the interest earned by the principal is net paid at the end of each interest period but is
considered as added to the principal and therefore will also earn interest for the succeeding periods. The interest earned
by the principal when invested at compound interest is much more than that earned by the same principal when invested
at simple interest for the same number of periods.
Using the same nomenclature as that for simple interest, the total amount due after n periods for compound
interest is given by the formula:
n
F=P ( 1+i )

n
which is derived in accordance with simple interest formula. The factor ( 1+i ) is called the “Single Payment
Compound Amount Factor”.

Table 2.3.1 Derivation of Formula

Interest Principal at beginning of Interest earned during Compound amount at the end of the
Period the period period period
1 P Pi P+ Pi=P(1+i)
2 P(1+i) P ( 1+ i ) i P ( 1+ i ) + P ( 1+i ) i=P(1+i)(1+i)

3 P ( 1+ i )
2
P ( 1+ i ) i
2 2 2
P ( 1+ i ) + P ( 1+ i ) i=P ( 1+ i ) (1+i )
2

.………… .………… .………… .…………

n−1 n−1 n−1 n −1 n−1
n P ( 1+ i ) P ( 1+ i ) i P ( 1+ i ) + P ( 1+ i ) i=P ( 1+i ) ( 1+ i ) =P ( 1+i )n

In order to apply the formulas of simple and compound interest and type of interest, you must understand and
analyze some examples. The mathematical formula for compound interest depends on several factors. These factors
include the amount of money deposited called the principal, the annual interest rate (in decimal form), the number times
the money is compounded per year and the number of years the money is left in the bank. These factors lead to the
formula
where: F = Future value of the deposit

( )
mn
i P = Principal or amount of money deposited
F=P 1+
m I = annual interest rate (in decimal form)
m = number times the money is compounded per year
n = number of period in years

Frequency of the Number of periods, n

Compounding of Interest during a 1 year time span
Annually 1
Semi-annually 2
Quarterly 4
Monthly 12
Daily 365

Sample Problems:
1. If the sum of ₱12,000 is deposited in an account in an earning interest at the rate of 9% compounded quarterly,
what will it become at the end of 8 years?
2. At a certain interest rate compounded quarterly, ₱1,000 will amount to be ₱4,500 in 15 years. What is the amount
at the end of 10 years?
3. You deposit ₱600.00 into a savings account. How much money do you have after 3 years if the account has a 4%
interest rate, and the interest is compounded annually?
4. Mr. Bacani borrowed money from the bank. He received from the bank ₱1,842.00 and promised to repay ₱2,000
at the end of 10 months. Determine the rate of interest.
5. You borrow ₱5,000 for one year from a friend at an interest rate of 1.5% per month instead of taking a loan from a
bank at a rate of 18% per year. How much lesser you will pay by borrowing the money from the bank?