Simple and Compound

Interest

Dina Agustina, S.Pd., M.Sc.

Mathematics Study Programme

Universitas Negeri Padang
2021
Definition
• Interest is the compensation (money) that a borrower give
to a lender

• Capital (Principal): the initial amount of money invested

• Period: the unit in which time is measured (one year)
• Accumulated Value: the total amount received after a
period of time
• Interest is the difference between the accumulated value
and principal.
The Accumulation and Amount Function
Suppose we invest one unit of principal, the accumulation function 𝑎(𝑡)
is total amount that we get during period of time 𝑡 ≥ 0 of an initial
investment of 1.

The properties of accumulation function:

1. a 0 = 1
2. a t is an increasing function.
3. If the interest increases continuously then it is called a
continuous function, but sometimes the interest does not
increase continuously then it is called a discontinuous
function.
• In general, the money invested is not 1, it can be a certain
amount 𝑘 > 0.
• Amount function 𝐴(𝑡) which gives the accumulated value at
time t ≥ 0 of the initial investment 𝑘.

𝐴 𝑡 = 𝑘. 𝑎(𝑡) 𝐴 0 =𝑘

𝐼𝑛 = total interest earned during

the n-th period

𝐼𝑛 = 𝐴 𝑛 − 𝐴(𝑛 − 1)
 An investment of $10.000 is made into a fund at time 𝑡 = 0.
The fund develops the following balances over the next 4 years:
𝒕 𝑨(𝒕)
0 10,000.00
1 10,600.00
2 11,130.00
3 11,575.20
4 12,153.96

If $5000 is invested at time 𝑡 = 2, under the same interest environment, find

the accumulated value of the $5000 at time 𝑡 = 4

Let X be the accumulated value of the $5000. X can be determined by ratio

and proportion
𝑋 12,153.96
=
5000 11,130.00
𝑋 = 5460
The Effective Rate of Interest
• Definition
The effective rate of interest is the ratio of the amount of interest
earned during the period to the amount of the principal invested at
the beginning of the period.

𝑎 𝑛 − 𝑎(𝑛 − 1)
𝑖𝑛 = Where 𝑛 = 1,2,3, …
𝑎(𝑛 − 1)
 Simple Interest
• Suppose we have a principal 1 or we can express it as 𝑎 0 = 1,then after 1 year
of saving, we get interest at the end of the year.

Interest Total amout/

Principal accumulation function
i
1 1+i 𝒂 𝟏 =𝟏+𝒊

0 1 Period/time

Principal • In General
i i i i 𝒂 𝒕 = 𝟏 + 𝒊t
1 …
0 1 2 3 𝑡−1 𝑡

The interest earned from the above pattern is called simple interest
Relationship between simple interest and the effective rate of
interest.

𝑎 𝑛 − 𝑎(𝑛 − 1) 1 + 𝑖𝑛 − 1 + 𝑖(𝑛 − 1) 𝑖
𝑖𝑛 = = = 1 + 𝑖(𝑛 − 1)
𝑎(𝑛 − 1) 1 + 𝑖(𝑛 − 1)

Where 𝑛 = 1,2,3, …

A constant rate of simple interest give an impact for a decreasing

effective rate of interest
Initial amount $2000 invested for four years, if the rate of simple interest is 8%
per annum. Find
a. The accumulated value
b. The total interest
c. The effective rate of interest for the fourth year

Given: P = 2000, 𝑖 = 8%, 𝑡 = 4

Ask:
a. 𝐴 4 = ⋯ ?
b. I = ⋯?
c. 𝑖4 = ⋯ ?
Answer:
a. 𝐴 4 = 𝑘. 𝑎 4 = 2000 1 + 0.08 ∗ 4 = $2640
b. 𝐼 = 𝑃𝑖𝑡 = 2000 ∗ 0.08 ∗ 4 = 640
𝑖 0.08
c. 𝑖4 = =
1+𝑖(𝑛−1)
= 0.0645 or 6.45%
1+0.08(4−1)
 Compound Interest
• Compound interest emerge to handle that interest not
reinvested (interest automatically reinvested)
• Compound means the process to reinvested the interest
(𝑖 + 1) + 𝑖(𝑖 + 1)
= 1+𝑖 2 1+𝑖 𝑡

1+i

Principal
i i i i
1 …
𝐭
1 𝑡−1 𝑡
𝒂 𝒕 = 𝟏+𝒊
0 2 3
Relationship between compound interest and the effective
rate of interest

𝑎 𝑛 − 𝑎(𝑛 − 1) 1+𝑖 𝑛 − 1+𝑖 𝑛−1 1+𝑖 −1

𝑖𝑛 = = = =𝑖
𝑎(𝑛 − 1) 1 + 𝑖 𝑛−1 1

Where 𝑛 = 1,2,3, …

The compound interest and the effective rate of interest are

equal.
Find the accumulated value of $2000 invested for four years, if the
rate of compound interest is 8% per annum.

Given: P = 2000, 𝑖 = 8%, 𝑡 = 4

Ask:
𝐴 4 = ⋯?
Answer:
4
𝐴 4 = 𝑘. 𝑎 4 = 2000 1 + 0.08 = $2720.98
Find the accumulated value of $5000 at the end of 5 year and 4 months invested at 9%
per annum
1. Assuming compound interest throughout
2. Assuming simple interest during the final fractional period.

1. Assuming compound interest throughout

1 5
1
𝐴 5 = 5000 1.09 3 = $7197.322.
3

2. Assuming simple interest during the final fractional period.

1
𝐴 5 = 5000 1.09 5 1.03 = $7923.91
3

The answer part (2) is larger than part (1), we can conclude that simple interest
produces larger accumulated values over fractional periods than compound interest
doses, although the difference is small