Simple Interest

Simple Interest
In simple interest, only the original principal bears interest and the interest to be paid varies
directly with time.
The formula for simple interest is given by

I=Prt

The future amount is

F=P+I
F=P+Prt
F=P(1+rt)

Where
I = interest
P = principal, present amount, capital
F = future amount, maturity value
r = rate of simple interest expressed in decimal form
t = time in years, term in years
Ordinary and Exact Simple Interest
In an instance when the time t is given in number of days, the fractional part of the year will be
computed with a denominator of 360 or 365 or 366. With ordinary simple interest, the
denominator is 360 and in exact simple interest, the denominator is either 365 or 366. We can
therefore conclude that ordinary interest is greater than exact interest.
Note:
When simple interest (ordinary or exact) is not specified in any problem, it is assumed as
ordinary.

Ordinary simple interest is computed on the basis of bankers year.

Bankers year
1 year = 12 months
1 month = 30 days (all months)
1 year = 360 days

Exact simple interest is based on the actual number of days in a year. One year is equivalent to
365 days for ordinary year and 366 days for leap year. A leap year is when the month of February
is 29 days, and ordinary year when February is only 28 days. Leap year occurs every four years.
Note:
Leap years are those which are exactly divisible by 4 except century years, but those century
years that are exactly divisible by 400 are also leap years.
If d is the number of days, then ...
In ordinary simple interest

t=d360

In exact simple interest

t=d365

(for ordinary year)

t=d366

(for leap year)

ompound Interest
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In compound interest, the interest earned by the principal at the end of each interest period
(compounding period) is added to the principal. The sum (principal + interest) will earn another
interest in the next compounding period.
Consider $1000 invested in an account of 10% per year for 3 years. The figures below shows the
contrast between simple interest and compound interest.

At 10% simple interest, the $1000 investment amounted to $1300 after 3 years. Only the
principal earns interest which is $100 per year.

At 10% compounded yearly, the $1000 initial investment amounted to $1331 after 3 years. The
interest also earns an interest.

Elements of Compound Interest

P = principal, present amount
F = future amount, compound amount
i = interest rate per compounding period
r = nominal annual interest rate
n = total number of compounding in t years
t = number of years
m = number of compounding per year

i=rm

Future amount,

and

n=mt

F=P(1+i)n
The factor

(1+i)n

or

F=P(1+rm)mt

is called single-payment compound-amount factor and is denoted by

(F/P,i,n).
Present amount,

P=F(1+i)n
The factor

1(1+i)n

is called single-payment present-worth factor and is denoted by

(P/F,i,n).

Number of compounding periods,

n=ln(F/P)ln(1+i)

Interest rate per compounding period,

i=FPn1

Values of i and n
In most problems, the number of years t and the number of compounding periods per year
m are given. The example below shows the value of i and n.
Example
Number of years, t=5 years
Nominal rate, r=18%

Compounded annually (m=1)

n=1(5)=5
i=0.18/1=0.18

Compounded semi-annually (m=2)

n=2(5)=10
i=0.18/2=0.09

Compounded quarterly (m=4)

n=4(5)=20
i=0.18/4=0.045

Compounded semi-quarterly (m=8)

n=8(5)=40
i=0.18/4=0.0225

Compounded monthly (m=12)

n=12(5)=60
i=0.18/12=0.015

Compounded bi-monthly (m=6)

n=6(5)=30
i=0.18/6=0.03

Compounded daily (m=360)

n=360(5)=1800
i=0.18/360=0.0005

Continuous Compounding (m )
In continuous compounding, the number of interest periods per year approaches infinity. From
the equation

F=(1+rm)mt

m, mt=, and rm0.

F=Plimm(1+rm)mt
when

Let

x=rm.

When

m, x0,

Hence,

and

m=rx.

F=Plimx0(1+x)rxt
F=Plimx0(1+x)1xrt
From Calculus,

limx(1+x)1/x=e,

thus,

F=Pert