4.1.

Simple and Compound

Interest
Interest
The amount of money earned for the use of borrowed capital is called interest. From
the borrower’s point of view, interest is the amount of money paid for the capital. For
the lender, interest is the income generated by the capital which he has lent. There are
two types of interest, simple interest and compound 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 given by

F=P+I;F=P+(Prt)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

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 that 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 banker’s year.

Banker’s 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 that 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
d
t=
360
In exact simple interest
d
t= →for ordinary year
365
d
t= →for leaf year
365

Compound Interest
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

r
i= and n = mt
n
For future amount,

F=P ¿ or F=P ¿

The factor (1+i)n(1+i)n is called single-payment compound-amount factor and is denoted

by (F/P,i,n)

For present amount,
+F
P= n
(1+i)
1
The factor  n is called single-payment present-worth factor and is denoted by (P/F,i,n)
(1+i)
Number or compounding periods,
 F
+ ¿( )
P
n=
¿(1+i)
Interest rate per compounding period,

F
i=
√
n

P
-1

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)=5n=1(5)=5
0.18
i= = 0.18
1
Compounded semi-annually (m=2)

n=2(5)=10n=2(5)=10
0.18
i= = 0.09
2
Compounded quarterly (m=4)
0.18
i= = 0.045
4
Compounded semi-quarterly (m=8)

n=8(5)=40n=8(5)=40
0.18
i= = 0.0225
8
Compounded monthly (m=12)

n=12(5)=60n=12(5)=60
 0.18
i= = 0.015
12
Compounded bi-monthly (m=6)

n=6(5)=30n=6(5)=30
0.18
i= = 0.03
6
Compounded daily (m=360)

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

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

f =¿

r
whenm⟶∞,mt=∞,and m ⟶0.Hence,

r
F=P lim ¿m ¿ ⟶∞(1+ ¿mt
m
r r
Let x= m When m⟶∞,x =0,and m = m
r
F=P lim ¿x ⟶ 0¿ ( 1+ x¿ x t
r
F=P lim ¿x ⟶ 0¿ ( 1+ x¿ x r t
1
FromCalculus,limx⟶∞(1 + x¿ x =e, thus,

F= Pe rt