Chapter 5

The Mathematics of Finance

Learning Outcomes:

At the end of the chapter, the students shall be able to:

1. differentiate simple and compound interest

5.1 Simple Interest

When you deposit money in a bank—for example, in a savings account—you are

permitting 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 Php1000
in a savings account paying 5% interest, Php1000 is the principal and the interest rate is 5%. Interest paid on the original
principal is called simple interest. The formula used to calculate simple interest is given below.

The simple interest formula is I = Prt,

where I is the interest, P is the principal, r is the interest rate, and t is the time period. In the simple interest formula, the time t
is expressed in the same period as the rate. For example, 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 percent. Before performing calculations involving an interest rate,
write the interest rate as a decimal.

Example 1. Calculate the simple interest earned in 1 year on a deposit of P1000 if the interest rate is 5%.

Solution:
Use the simple interest formula. Substitute the following values into the formula:
P = 1000, r = 5%, and t = 1
I = Prt
I = 1000(0.05)(1)
I = 50
The simple interest earned is P50.

Example 2. Calculate the simple interest due on a three-month loan of P2000 if the interest rate is 6.5%.

Solution:
Use the simple interest formula. Substitute the following values into the formula:

P = 2000, r = 6.5% = 0.065. Because the interest rate is an annual rate, the time must be measure in years:
3 months 3
𝑡 = ̅̅̅̅̅̅̅̅̅̅̅̅̅̅ = ̅̅̅̅
12 months 12
I = Prt
I = 2000(0.065)(3/12)
I = 32.5

The simple interest due is P32.50.

Example 3. Calculate the simple interest due on a two-month loan of P500 if the interest rate is 1.5% per month.

Solution:
Use the simple interest formula. Substitute the following values into the formula:

P = 500, r = 1.5% = 0.015. Because the interest rate is per month, the time period of the loan is expressed as
the number of months 𝑡 = 2
I = Prt
I = 500(0.015)(2)
I = 15
 The simple interest due is P15.

Remember that in the simple interest formula, time t is measured in the same period as the interest rate. Therefore, if
the time period of a loan with an annual interest rate is given in days, it is necessary to convert the time period of the loan to a
fractional part of a year. There are two methods for converting time from days to years; the exact method and the ordinary
method. Using the exact method, the number of days of the loan is divided by 365, the number of days in a year.

number of days
Exact method: 𝑡 =
̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅
365

The ordinary method is based on there being an average of 30 days in a month and 12 months in a year (30)(12) =
360. Using this method, the number of days of loan is divided by 360.

number of days
Ordinary method: 𝑡 =
̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅
360

Example 4. Calculate the simple interest due on a 45-day loan of P3500 if the interest rate is 8% per month.

Solution:
Use the simple interest formula. Substitute the following values into the formula:
P = 3500, r = 8% = 0.08. Because the interest rate is per month, the time period of the loan is expressed as
45
the number of months 𝑡 = .
360
I = Prt
I = 3500(0.08)(45/360)
I = 35
The simple interest due is P35.

The simple interest formula can be used to find the interest rate on a loan when the interest, principal, and time period
of the loan are known. An example is given below.

Example 5. The simple interest charged on a six-month loan of P3000 is P150. Find the simple interest rate.
Solution
Use the simple interest formula. Solve the equation for r.
I = Prt
150 = 3000(r)(6/12)
150 = 1500r (divide both sides by 1500 to find the r)
0.10 = r, r = 10%

The simple interest rate on the loan is 10%.

Exercise 5.1

A. In items 1 – 5, calculate the simple interest earned. Show your solution

No. Principal (P) Rate (r) Time (t) Interest(I)

1 2000 6% 1 year

2 12,000 7.8% 45 days

3 3000 9.6% 21 days

4 3500 1.8% 4 months

5 7000 7.2% 114 days

B. In items 6 – 10, solve each of the following problems

1. Calculate the simple interest earned in 1 year on a deposit of P1900 if the interest rate is 8%.
2. Calculate the simple interest earned in 1 year on a deposit of P2300 if the interest rate is 7%.
3. You deposit P1500 in an account earning 10.4% interest. Calculate the simple interest earned in 6 months.
 4. Calculate the simple interest due on 150-day loan of P4800 if the interest rate is 7.25%.
5. Calculate the simple interest due on a two-month loan of P800 if the interest rate is 1.5% per month.

5.2 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 the interest calculated not only on the original principal,
but also on any interest that has already been earned.
To illustrate compound interest, suppose you deposit P1000 in a savings account earning 5% interest, compounded
annually (once a year).

During the first year, the interest earned is calculated as follows.

I = Prt
I = 1000(0.05)(1) = 50

At the end of the first year, the total amount in the account is
A=P+I
A = 1000 + 50 = 1050

During the second year, the interest earned is calculated using the amount in the account at the end of the first year.

I = Prt
I = 1050(0.05)(1) = 52.50

Note that the interest earned during the second year (P52.50) is greater than the interest earned during the first year
(P50). This is because the interest earned during the first year was added to the original principal, and the interest for the
second year was calculated using this sum. If the account earned simple interest rather than compound interest, the interest
earned each year would be the same (P50).

At the end of the second year, the total amount in the account is the sum of the amount in the account at the end of
the first year and the interest earned during the second year.
A=P+I
A = 1050 + 2.50 = 1102.50

The interest earned each year keeps increasing. This is the effect of compound interest.
In the given example, the interest is compounded annually. However, compound interest can be compounded semi-
annually (twice a year), quarterly (four times a year), monthly or daily. The frequency with which interest is compounded is the
compounding period.

If, in the preceding example, interest is compounded quarterly rather than annually, then the first interest payment on
3 1
the P1000 in the account occurs after 3 months (𝑡 = = ; 3 months is one quarter of a year). That interest is then added to
12 4
the account, and the interest earned for the second quarter is calculated using that sum.

End of 1st quarter: I = Prt = (1000)(0.50)(3/12) = 12.50

A = P + I = 1000 + 12.50 = 1012.50

End of 2nd quarter: I = Prt = (1012.50)(0.50)(3/12) = 12.65625

A = P + I = 1012.50 + 12.66 = 1025.16

End of 3rd quarter: I = Prt = (1025.16)(0.50)(3/12) = 12.81

A = P + I = 1025.16 + 12.81 = 1037.97

End of 4th quarter: I = Prt = (1037.97)(0.50)(3/12) = 12.97

A = P + I = 1037.97 + 12.97 = 1050.94
The total amount in the account at the end of the first year is P1050.94.

Example 1. (Future Value)

You deposit P500 in an account earning 6% interest, compounded semi-annually. How much is in the account
at the end of 1 year?
 Solution: The interest is compounded every 6 months. Calculate the amount in the account after the first 6
months. t = 6/2

A = P(1 + rt)
A = 500[1 + 0.06(6/12)]
A = 515

Calculate the amount in the account after the second 6 months.

A = P(1 + rt)
A = 515[1 + 0.06(6/12)]
A = 530.45
The total amount in the account at the end of 1 year is P530.45

Compound Interest Formula

𝑟
𝐴𝑛 = 𝐴𝑜 (1 + )𝑛𝑠 where An = total amount (interest +principal)
𝑠
Ao = principal invested (original amount)
r = rate of annual interest
n = no. of times per year the interest is compounded
s = no. of years the principal is invested

Example 1. How much money will Mr. Agustin have at the end of 5 years if he deposits P1000 at 9% interest
compounded semi-annually?
𝑟
Solution: Using the formula, we have 𝐴𝑛 = 𝐴𝑜 (1 + )𝑛𝑠
𝑠
0.09 2(15)
𝐴𝑛 = 1000(1 + )
2
𝐴𝑛 = 𝑃1552.97

Example 2. Mang Lando invested P25,000 at an annual interest rate of 8% compounded quarterly. Find the total
amount at the end of 5 years.
𝑟
Solution: Using the formula, we have 𝐴𝑛 = 𝐴𝑜 (1 + )𝑛𝑠
𝑠
0.08 5(4)
𝐴𝑛 = 25000(1 + )
4
𝐴𝑛 = 𝑃37100

Try this
Using example no. 2, how much money will Mang Lando have if interest is compounded
a. Quarterly
b. Monthly
c. Daily

Exercise 5.2

A. In items 1 – 5, calculate the compound amount using the formula

No. Principal (P) Rate (r) mode Time (t) Amount (A)

1 1200 7% Semi-annually 12 yrs

2 3500 8% Semi-annually 14 yrs

3 1700 9% daily 5 yrs

4 9600 6% monthly 3 yrs

5 8600 11% Bi-monthly 3 yrs

B. Solve each of the following problems

1. On his 18th birthday, Merly’s parents placed P10,000 in time deposit at 10% compounded monthly. In 10 years,
how much money would be available for her educational expenses?

2. For the college education of his son, the father of a 7-year old boy wants to put enough money in time deposit at
14% annual interest compounded yearly. How much must he deposit ti have P60,000 when his son reaches 18
years old?