SIMPLE AND COMPOUND INTEREST

INTENDED LEARNING OUTCOMES

At the end of the lesson, the learner is able to:

ˆ illustrate simple and compound interests

ˆ recognize the difference between simple and compound interest

ˆ calculate compound interest using different compounding frequencies.

ˆ evaluate the impact of compounding frequency on the total amount of interest earned.

ˆ compute interest, maturity value, future value, and present value in simple interest and com-
pound interest environment.

ˆ solve real-life problems involving simple and compound interests.

TOPIC OUTLINE:
1. Simple Interest
2. Compound Interest

If a person saves money in a bank, he is permitting the bank to use his money. The bank may
lend his deposited money to customers to start a business, to buy cars, or make renovations on their
homes. The bank pays the depositor for the privilege of using his money. The amount paid to him
is called interest. On the other hand, if a person borrows money from a bank, the amount he pays
for the privilege of using that money is also called interest. Hence, money has present and future
values.

Definitions of Terms:

ˆ Lender or creditor–person (or institution) who invests the money or makes the funds available

ˆ Borrower or debtor – person (or institution) who owes the money or avails of the funds from
the lender
ˆ Origin or loan date – date on which money is received by the borrower.

ˆ Repayment date or maturity date –date on which the money borrowed or loan is to be
completely repaid
ˆ Time or term (t)– amount of time in years the money is borrowed or invested; length of time
between the origin and maturity dates
ˆ Principal (P)– amount of money borrowed or invested on the origin date

ˆ Rate(r)– annual rate, usually in percent, charged by the lender, or rate of increase of the
investment
ˆ Interest (I)– amount paid or earned for the use of money

ˆ Simple Interest (Is) – interest that is computed on the principal and then added to it

ˆ Compound Interest (Ic)–interest is computed on the principal and also on the accumulated
past interests
ˆ Maturity value or future value (F) –amount after t years that the lender receives from the
borrower on the maturity date

EXAMPLE 1. Suppose you won P 30, 000.00 and you plan to invest it for 5 years. A
cooperative group offers 2% simple interest rate per year. A bank offers 2% compounded
annually. Which will you choose and why?

SOLUTION.
Investment 1: 2% simple interest rate per year

Investment 2: 2% compounded annually

Let us compare the interest earned in the two investments.

Investment 1:
Simple Interest: P 33,000.00 - 30,000.00 = P 3,000.00

Investment 2:
Compound Interest: P 33,122.42 - 30,000.00 = P 3,122.42
 Simple interest remains constant throughout the investment term. In compound interest, the
interest from the previous year also earns interest. Thus, the interest grows every year.

TOPIC OUTLINE:

1. Compute simple interest

2. Compute the unknown principal, rate or time
3. Compute maturity value
4. Solving real-life problems involving simple interest

Simple interest is interest in which only the original amount of money borrowed or deposited,
also known as the principal, bears interest for the entire term of the loan. The formula used to
calculate simple interest is given below.

Interest rates are generally given as percent. Before performing calculations involving an interest
rate, write the interest rate as a decimal.

Example 1: A bank offers 0.35% annual simple interest rate for a particular deposit. How
much interest will be earned if 1 million pesos is deposited in this savings account for 2 year?
SOLUTION.

Given:

P = P 1, 000, 000.00
r = 0.35% = 0.0035
t = 2 years

Find: Is .

Is = Prt = (1, 000, 000)(0.0035)(2) = P 7, 000

ANSWER: The simple interest earned is P 7, 000.

Example 2: How much interest is charged when P 40, 000.00 is borrowed for 9 months at
an annual interest rate of 8%?

SOLUTION.

Given:

P = P 40, 000.00
r = 8% = 0.08
9
t = 9 months =⇒ t = = 0.75 year
12
M
Note: When the term is expressed in months (M ), it should be converted in years by t = 12
.

Find: Is .
9
Is = Prt = (40, 000)(0.08) = (40, 000)(0.08)(0.75) = P 2, 400
12
ANSWER: The simple interest charged is P 2, 400.
 Algebraically, from the formula of simple interest, we can derive the formulas for principal P,
rate of interest r, and the time or term t. These formulas are as follows.
I I I
P = ; r= ; t=
rt Pt Pr

Example 3: The simple interest charged on a 6-month loan of P 8, 000.00 is P 480.00. Find
the annual simple interest rate.

SOLUTION.

Given:
6
P = P 8, 000.00 ; t= ; I = 480
12
Find: r
I 480
r= = 6 = 0.12 = 12%
Pt (8, 000)( 12 )
ANSWER: The simple interest rate on the loan is 12%.

Example 4: Complete the table below by finding the unknown values.

Principal (P) Rate (r) Term (t) Interest (Is )

(a) 3.5% 2.5 years P 3,937.50

P 50,000.00 (b) 4 years P 23,000.00

P 65,000.00 9.5% (c) P 16,981.25

P 250,000.00 10 25 % 39 months (d)

SOLUTION.

Is 3, 937.5 Is 23, 000

(a) P = = = P 45,000 ; (b) r = = = 0.115 = 11.5%
rt (0.035)(2.5) Pt (50, 000)(4)
 Is 16, 981.25
(c) t = = = 2.75 years
Pr (65, 000)(0.095)

 39 
(d) Is = P rt = (250, 000)(0.104) = (250, 000)(0.104)(3.25) = P 84,500.00
12

Example 5: A businessman charges his client P 3, 565.75 on a loan of P 15, 800.00 for 2
years and 3 months. What annual simple interest rate is he using?

SOLUTION.

Given:
3
P = P 15, 800.00 ; t=2 = 2.25; I = 3, 565.75
12
Find: r
I 3, 565.75
r= = 3 = 0.1003 = 10.03%
Pt (15, 800)(2 12 )

Example 6: How long will it take for P 25, 250.00 to earn P 5, 555.00, if it is invested at 8%
annual simple interest?

SOLUTION.

Given:

P = 25, 250.00 ; Is = 5, 555.00; r = 8%

Find: t
I 5, 555
t= = = 2.75 = 2 years and (0.75)(12) months = 2 years and 9 months
Pr (25, 250)(0.08)
 Example 7: A principal earns a simple interest of P 11, 911.69 in 18 months at an annual
simple interest rate of 9 14 %. Find the principal invested.

SOLUTION.

Given:
18 1
I = 11, 911.69 ; t= = 1.5 year; r = 9 % = 9.25% = 0.0925
12 4
Find: P
I 11, 911.69
P = = = P 85,850.02
rt (0.0925)(1.5)

Maturity (Future) 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

F = P + Is (1)
where F is the maturity (future) value after the simple interest, Is , has been
added to the principal, P.

Substituting Is by P rt gives the formula given below.

Future Value or Maturity Value Formula for Simple Interest

The future or maturity value formula for simple interest is

F = P + P rt = P (1 + rt) (2)
where F is the maturity (future) value, r is the simple interest rate, t is the
term, and P is the principal.

Note that formulas (1) and (2) can be used depending on what is the given in the problem.

Example 8: A man borrows P 6, 000.00 for 6 months at simple interest rate of 10%. What
amount must he repay?
SOLUTION.
6
Given: P = 6, 000 ; t= = 0.5 year; r = 0.10
12
Find: F

Since the given are P, r, and t, it would be easier to use formula (2). However, if you insist
using fomula (1) you can use it.
6 
F = P (1 + rt) = 6, 000(1 + (0.1) ) = P 6,300.00
12
Thus, the man should pay P 6,300.00.

Suppose we will use formula (1): F = P + Is

Step 1. Solve Is = P rt = (6, 000)(0.1)(0.5) = P 300

Step 2. Solve F = P + Is = 6, 000 + 300 = P 6,300.00

Thus, the man should pay P 6,300.00.

Algebraically, from the formula of maturity value, we can derive the another formulas for
principal P, simple interest Is , rate of interest r, and the time or term t. You will use these
formulas depending on what is given in the problem. These formulas are as follows.
F F −P F −P
P = F − Is ; P = ; Is = F − P ; r= ; t=
1 + rt Pt Pr

Example 9: The maturity value of a 3-month loan of P 5, 000.00 is P HP 5, 125.00. What is

the simple interest rate?

SOLUTION.
3
Given: P = 5, 000 ; F = 5, 125; t= = 0.25
12
Find: r
 F −P 5, 125 − 5, 000
r= = = 0.1 = 10%
Pt (5, 000)(0.25)

Thus, the simple interest rate used here is 10%.

Example 10: How much should you invest at the simple interest rate of 8.5% in order to
have P 175,500.00 in 2 years?

SOLUTION.

Given: F = P 175, 500 ; t = 2 years; r = 0.085

Find: P

F 175, 500
P = = = P 150,000.00
1 + rt 1 + (0.085)(2)

Example 11: Complete the table below by finding the unknown values.

Principal (P) Rate (r) Term (t) Maturity Value, (F)

(a) 12.4% 3.5 years P P122,535.30

P 15,750.00 (b) 3 years P 20,575.00

P 150,000.00 9.5% (c) P 187,150.00

P 250,000.00 10 25 % 39 months (d)

 SOLUTION.

F 122, 535.30
(a) P = = = P 85,450.00
1 + rt 1 + (0.124)(3.5)

F −P 20, 575 − 15, 750

(b) r = = = 0.102 = 10.2%
Pt (15, 750)(3)

F −P 187, 150 − 150, 000

(c) t = = = 2.6 years = 2 yeaars and 7 months
Pr (150, 000)(0.095)
To get 7 months: 0.6 x 12 months = 7 months
 39 
(d) F = P (1 + rt) = 250, 000(1 + (0.104) = 250, 000(1 + (0.104)(3.25) = P 334,500.00
12
Note that 10 52 % = 10.4% = 0.104 and 39
12
= 3.25.

=====================PRACTICE=====================

Solve the following problems on simple interest

1) At what simple interest rate per annum will P 35,500 accumulate to P 61,000.00 in 6 years and 9
months?

2) How long will P 18,500.00 amount to P 40,500.00 if the simple interest rate is at 11.5% per annum?

3) You deposit P 12,780.00 in an account paying 9 34 % simple interest. Find the future value of the
investment after 5 years.

4)Suppose that Rick loans Liza P 24, 500.00 at a simple interest rate of 10.8% for 1 year. How much
interest will Liza pay?

Answers:

1) r = 10.6%
2) t = 10.3 years = 10 years and 4 months
3) F = P 19, 010.25
4) Is = P 2, 646.00
TOPIC OUTLINE:

1. Compute compound amount or maturity value, compound interest, and present value.
2. Solving Interest Rate and Time in Compound Interest
3. Solving real-life problems involving compound interest

In topic 1 example 1, we have seen that simple interest remains constant throughout the invest-
ment term. In compound interest, the interest from the previous year also earns interest. Thus, the
interest grows every year. In this lesson, we will investigate compound interest more and see how it
differs from simple interest.

Definitions of Terms

ˆ Compound amount (F) – also called maturity value, it is an accumulated amount obtained
by adding the original principal and the compound interest.

ˆ Annual Conversion period (m) – the number of times in a year the interest will be com-
pounded. The following are the common conversion periods in a year.

(a) annually : m=1

(b) semi-annually : m=2
(c) quarterly : m=4
(d) monthly : m = 12

ˆ Number of conversion periods (n) – the total number of times interest is calculated for
the entire term of the investment or loan. Note that n = tm.

ˆ Annual interest rate or nominal rate (r) – the stated rate of interest per year.
r
ˆ Periodic rate (i) – the interest rate per conversion period. Note that i = .
m
ˆ Present value of F (P) – the original principal P invested, or the value of the investment
before it earns any interest. This amount 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.

NOTE:
1) annually means once a year, that is why m = 1;
2) semiannually means every 6 months, so that it is twice every year, m = 2;
3) quarterly means every three months, so that it is four times every year, m = 4; and
4) monthly means every month, so that m = 12.
 In the previous lesson, we already know that no matter how long the loan continues, under simple
interest the borrower pays (and lender receives) interest only on the original principal, not on any
interest that accumulates along the way.

With compound interest, interest is paid on both the original principal and on any interest that
accumulates along the way.

In this type of interest, the interest due at stipulated interval is added to the principal and earns
interest thereafter. It implies that the principal increases over a period of time, resulting to an
increase in interest earned at every compounding period. Thus, compound interest is an interest
resulting from the periodic addition of simple interest to the principal amount or simply the differ-
ence between the compound amount and the original principal.

To see how this works, consider the example below.

Example 1: Suppose you deposit P 10, 000.00 in a savings account earning 5% interest, com-
pounded annually (once a year). How much is the compound interest earned after 5 years?

SOLUTION.

Given:

P = P 10, 000.00; r = 5% = 0.05; t = 5 years;

r 0.05
m = 1 (annually); n = tm = 5 i= = = 0.05
m 1

Year’s Beginning Year’s End

Year Principal Interest Amount
1st 10,000.00 10,000 x 0.05 = 500.00 P10,000 + 500 = 10,500.00
2nd 10,500.00 10,500 x 0.05 = 525.00 10,500 + 525 = 11,025.00
3rd 11,025.00 11,025 x 0.05 = 551.25 11,025 + 551.25 = 11,576.25
4th 11,576.25 11,576.25 x 0.05 = 578.81 11,576.25 + 578.81 = 12,155.06
5th 12,155.06 12,155.06 x 0.05 = 607.75 12,155.06 + 607.75 = 12,762.81

From the table above, you will find that after 5 years you have now a maturity valaue of P 12,762.81.
So that you earned a compound interest of P 2,762.81.

Comparing with simple interest, you have the maturity value

F = P (1 + rt) = 10, 000(1 + (0.05)(5)) = P 12, 500.00

and simple interest of Is = F − P = 12, 500 − 10, 000 = P 2, 500.00. Clearly, compound
interest is greater than simple interest.

As shown in the table above, the amount at the end of each year is equal to the sum of the
principal and the interest for that year.
Thus,
Amount for First Year = 10, 000 + (10, 000 × 0.05) = 10, 000(1 + 0.05)

Amount for Second Year = Amount for First Year + Interest of this amount

= 10, 000(1 + 0.05) + (10, 000(1 + 0.05))(0.05)

= 10, 000(1 + 0.05)(1) + (10, 000(1 + 0.05))(0.05)

= 10, 000(1 + 0.05)(1 + 0.05) (by factoring)

= 10, 000(1 + 0.05)2

Amount for Third Year = Amount for Second Year + Interest of this amount

= 10, 000(1 + 0.05)2 + (10, 000(1 + 0.05)2 )(0.05)

= 10, 000(1 + 0.05)2 (1) + (10, 000(1 + 0.05)2 )(0.05)

= 10, 000(1 + 0.05)2 (1 + 0.05) (by factoring)

= 10, 000(1 + 0.05)3

Amount for Fourth Year = Amount for Third Year + Interest of this amount

= 10, 000(1 + 0.05)3 + (10, 000(1 + 0.05)3 )(0.05)

= 10, 000(1 + 0.05)3 (1 + 0.05) (by factoring)

= 10, 000(1 + 0.05)4

Amount for Fifth Year = Amount for Fourth Year + Interest of this amount

= 10, 000(1 + 0.05)4 + (10, 000(1 + 0.05)4 )(0.05)

= 10, 000(1 + 0.05)4 (1 + 0.05) (by factoring)

= 10, 000(1 + 0.05)5

 Example 2: Suppose you deposit P 25, 000.00 in a savings account earning 6% interest, com-
pounded semiannually (twice a year). How much is the compound interest earned after 2 years?

SOLUTION.

Given:

P = P 25, 000.00; r = 6% = 0.06; t = 2 years;

r 0.06
m = 2 (semiannually); n = tm = (2)(2) = 4 i= = = 0.03
m 2
Note that in this problem, 1 period is 6 months. So that there will be n = 4 periods here.

Beginning of each Period End of each Period

Periods Principal Interest Amount
1st 25,000.00 25,000 x 0.03 = 750.00 25,000 + 750 = 25,750.00
2nd 25,750.00 25,750 x 0.03 = 772.50 25,750 + 772.50 = 26,522.50
3rd 26,522.50 26,522.50 x 0.03 = 795.68 26,522.50 + 795.68 = 27,318.18
4th 27,318.18 27,318.18 x 0.03 = 819.55 27,318.18 + 819.55 = 28,137.73
From the table above, you will find that after 2 years you have now a maturity valaue of P 28,137.73.
So that you earned a compound interest of P 3,137.73.

Comparing with simple interest, you have the maturity value

F = P (1 + rt) = 25, 000(1 + (0.06)(2)) = P 28, 000.00

and simple interest of Is = F − P = 28, 000 − 25, 000 = P 3, 000.00. Clearly, compound
interest is greater than simple interest.

As shown in the table above, the amount at the end of each period ( six months) is equal to
the sum of the principal and the interest for that period.

Thus,
Amount for First six months = 25, 000 + (25, 000 × 0.03) = 25, 000(1 + 0.03)

Amount for Second six months = Amount for First six months + Interest of this amount

= 25, 000(1 + 0.03) + (25, 000(1 + 0.03))(0.03)

= 25, 000(1 + 0.03)(1) + (25, 000(1 + 0.03))(0.03)

= 25, 000(1 + 0.03)(1 + 0.03) (by factoring)

= 25, 000(1 + 0.03)2

 Amount for Third six months = Amount for Second six months + Interest of this amount

= 25, 000(1 + 0.03)2 + (25, 000(1 + 0.03)2 )(0.03)

= 25, 000(1 + 0.03)2 (1) + (25, 000(1 + 0.03)2 )(0.03)

= 25, 000(1 + 0.03)2 (1 + 0.03) (by factoring)

= 25, 000(1 + 0.03)3

Amount for Fourth six months = Amount for Third six months + Interest of this amount

= 25, 000(1 + 0.03)3 + (25, 000(1 + 0.03)3 )(0.03)

= 25, 000(1 + 0.03)3 (1 + 0.03) (by factoring)

= 25, 000(1 + 0.03)4

Note that the compound amount at the end of each year is the previous year’s compound amount
multiplied by (1 + i). The exponent on (1 + i) is equal to the number of compounding periods.
Generalizing from this, we can state that the compound amount after n years is F = P (1 + i)n .

COMPOUND AMOUNT AND COMPOUND INTEREST FORMULA

The compound amount formula is

 r tm
F =P 1+ = P (1 + i)n
m

Ic = F − P

where

F is the compound amount or maturity value,

Ic is the compound interest
P is the amount of money deposited or borrowed or the epresent value of F ,
r is the annual interest rate,
m is the number of compounding periods per year,
annually (m = 1); semi-annually (m = 2); quarterly (m = 4); monthly (m = 12)
t is the number of years,
r
i is the periodic rate and i =
m
n is the total number of total number of conversion periods and n = tm.
 Example 3: Calculate the compound amount when P 35,700.00 is deposited in an account
earning 6.4% interest, compounded semiannually, for 5 years.

SOLUTION.

Given:

P = P 35, 700.00 ; r = 6.4% = 0.064; t = 5 years; m = 2 (semiannually)

Find: F
 (5)(2)
r tm 0.064
F =P 1+ = 35, 700 1 + = P 48,917.61
m 2
ANSWER: The compound amount or maturity value is P 48,917.61.

NOTE:
r 0.064
1) Periodic rate i = = = 0.032, and the total number of conversion periods is
m 2
n = tm = (5)(10).

2) Rounding off of values must be done on the final answer only.

Example 4: Calculate the compound amount and compound interest when P 50,000.00 is
deposited in an account earning 10.6% interest, compounded

(a) annually, for 4 years.

(b) semiannually, for 4 years.
(c) quarterly, for 4 years.
(d) monthly, for 4 years.

SOLUTION.

Given:

P = P 50, 000.00 ; r = 10.6% = 0.106; t = 4 years

 Find: F

(a) m = 1 (annually)
 (4)(1)
r tm 0.106
F =P 1+ = 50, 000 1 + = P 74,815.32
m 1
Ic = F − P = 74, 815.32 − 50, 000 = P 24,815.32

(b) m = 2 (semiannually)
 (4)(2)
r tm 0.106
F =P 1+ = 50, 000 1 + = P 75,578.27
m 2
Ic = F − P = 75, 578.27 − 50, 000 = P 25,578.27

(c) m = 4 (quarterly)
 (4)(4)
r tm 0.106
F =P 1+ = 50, 000 1 + = P 75,982.44
m 4
Ic = F − P = 75, 982.44 − 50, 000 = P 25,982.44

(d) m = 12 (monthly)
 (4)(12)
r tm 0.106
F =P 1+ = 50, 000 1 + = P 76,261.00
m 12
Ic = F − P = 76, 261.00 − 50, 000 = P 26,261.00

Example 5: Under the conditions of Example 4, find the periodic rate i, and total conversion
periods n for 4 years.

SOLUTION.

(a) m = 1 (annually)
r 0.106
i= = = 0.106; n = tm = 4(1) = 4
m 1
(b) m = 2 (semiannually)
r 0.106
i= = = 0.053; n = tm = 4(2) = 8
m 2
(c) m = 4 (quarterly)
r 0.106
i= = = 0.0265; n = tm = 4(4) = 16
m 4
(d) m = 12 (monthly)
r 0.106
i= = = 0.00883; n = tm = 4(12) = 48
m 12

Algebraically, from the formula of compound amount, we can derive the formulas for the
present value or original principal P, annual interest rate r, the time or term t, and the
compound interest Ic . These formulas are as follows.

 r −tm r
P =F 1+ = F (1 + i)−n i= ; n = tm
m m

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

Example 6: Find the present value of P 32, 000.00 due in 3 years and 6 months if money is
invested at 14% compounded quarterly.

SOLUTION.

Given:

F = P 32, 000.00 ; r = 14% = 0.14; t = 3.5 years

Find: P
 −(3.5)(4)
r −tm 0.14
P =F 1+ = 32, 000 1 + = 32, 000(1 + 0.035)−14 = P 19,769.02
m 4
ANSWER: The present value P that must be invested is P 19,769.02.
 Example 7: To help pay your college expenses, you borrow P 15, 000.00 and agree to repay
the loan at the end of 5 years at 12% interest, compounded monthly.
(a) What is the maturity value of the loan?
(b) How much interest are you paying on the loan?

SOLUTION.

Given:

P = P 15, 000.00 ; r = 12% = 0.12; t = 5 years; m =12

(a) Find: F
 5(12)
r tm 0.12
F =P 1+ = 15, 000 1 + = 15, 000(1 + 0.01)60 = P 27,250.45
m 12
ANSWER: Thus, the maturity value of the loan is P 27,250.45.

(b) Find: Ic

Ic = F − P = 27, 250.45 − 15, 000.00 = P 12,250.45

Example 8: Find the present value of :

(a) P 45, 000.00 due in 2 years and 9 months if the interest rate is 5% compounded quarterly.
(a) P 65, 000.00 due in 8 years and 6 months if the interest rate is 18% compounded monthly.

SOLUTION.

(a) Given: F = P 45, 000.00 ; r = 5% = 0.05; t = 2.75 years; m=4

Find: P
 −2.75(4)
r −tm 0.05
P =F 1+ = 45, 000 1 + = 45, 000(1 + 0.0125)−11 = P 39,252.49
m 4
(b) Given: F = P 65, 000.00 ; r = 18% = 0.18; t = 8.5 years; m = 12

Find: P
 −8.5(12)
r −tm 0.18
P =F 1+ = 65, 000 1 + = 65, 000(1 + 0.015)−102 = P 14,235.64
m 12
=================PRACTICE PROBLEMS=================

References

[1 ] Teaching Guide for Senior High School – General Mathematics Commission on Higher Edu-
cation (2016) pages 159-197.

[2 ] Biehler, T.J. (2008).The Mathematics of Money: Math for Business and Personal Finance
Decisions. New York:McGraw-Hill Companies.