Mathematics of Finance 1

Simple and Compound Interest

Lesson I. Simple and Compound Interest

Objectives:

At the end of the session, the students are expected to:

1. distinguish simple and compound interest;
2. solve real-life problems involving interest;
3. create an investment plan based on the types of interests.

Lesson Proper:

Almost everyday money is borrowed and loaned in different transactions due to some
individuals or entities that secure funds for their own purposes. When money is loaned from
any financial institutions, it represents an investment in a form of debt obligation. The lender
acquires income based on the interest charged from the investment.

The interest refers to the fee or payment for the use of money. Interest rates are
usually expressed as a percent of the amount borrowed, lent, deposited, or invested. Take
for example in a purchased car or any items obtained through credit card, the customer
borrows an amount equal to the purchase price from the credit card provider. The provider
makes an investment in the form of loan to the customer. The rate of return on the
investment is equal to the rate of interest charged to the customer.

There are two types of interests, the simple interest and compound interest. Simple
interest is interest that is charged on the principal amount and is paid at the end of the loan
period. The amount borrowed is called principal and the rate of interest is the percentage of
the principal that will be charged for a specific period of time (e.g. daily, weekly, monthly,
yearly, etc). The time refers to the period from the date the loan is made to the date the loan
becomes due or payable. The time is usually calculated on a per year basis. When a certain
amount of money is deposited or borrowed, the sum of money at the end of the period is
called maturity value or accumulated value. The maturity value is, therefore, equal to the
sum of the principal and the interest earned.

The following variables will be used to represent the following:

𝑃 = principal amount of the loan or investment

𝑟 = annual rate of interest
𝑡 = time period (term) of the loan or investment
𝐼 = amount of interest paid or received
𝑀 = maturity value of the loan or investment

A simple interest, denoted by 𝐼, is interest charged on the principal for the entire
duration or period of the loan. It is determined using the following formula:

Simple Interest (𝐼) = Principal (𝑃) x Rate (𝑟) x Time (𝑡)

𝐼 = 𝑃𝑟𝑡 (Formula 1)

Maturity Value (M) = Principal (𝑃) + Interest (𝐼)

𝑀 = 𝑃+𝐼 (Formula 1.1)

With the use of mathematical manipulation, the following formulas are derived:

KAREN MAE H. PALABRICA

 Mathematics of Finance 2
Simple and Compound Interest

𝐼
P = 𝑟𝑡 (Formula 1.2)

𝐼
𝑟= (Formula 1.3)
𝑃𝑡

𝐼
𝑡= (Formula 1.4)
𝑃𝑟

Notes:

 The rate of interest, expressed in percent (%) must be converted first to a

decimal number before it is substituted into the formula
 The time must be converted into a year before it is substituted into the simple
interest formula

Sample Problem No. 1:

Brent obtained a loan of ₱15,000.00 from a bank that charges 2% simple interest for
1
32 years. Determine the:
a. amount of interest per annum
b. total amount of interest due on the loan
c. maturity value of the loan

Given:
𝑃 = ₱15,000.00
𝑟 = 2% or 0.02
1
𝑡 = 3 years
2

Solutions:
a. Express 2% to 0.02 and use 1 year for the time per annum. Substitute the values in the
formula.
𝐼 = 𝑃𝑟𝑡
= ₱15,000.00 x 0.02 x 1
= ₱300.00
 The amount of interest per annum is ₱300.00
1
b. Express 2% to 0.02 and convert 3 2 years to 3.5 years. Substitute the values in the formula.
𝐼 = 𝑃𝑟𝑡
= ₱15,000.00 x 0.02 x 3.5
= ₱1,050.00
 The total amount of interest due on the loan is ₱1,050.00
c. Substitute the principal amount which is ₱15,000.00 and ₱1,050.00 as the amount of
interest due on the loan to the formula.
𝑀 = 𝑃+𝐼
= ₱15,000.00 + ₱1,050.00
= ₱16,050.00
 The maturity value of the loan is ₱16,050.00

A compound interest is the interest calculated periodically and added to the principal.
The time interval between succeeding interest calculations is called conversion period or
compounding period or interval period. The interest earned during a period is converted to
principal at the end of the period because the principal and the interest are combined and
treated as the new principal for the succeeding period. The effect of converting interest to

KAREN MAE H. PALABRICA

 Mathematics of Finance 3
Simple and Compound Interest

principal is that interest earned in a period will also earn interest in all succeeding periods.
The compound frequency or conversion frequency is the number of compoundings that take
place in a year. The common compounding or conversion frequencies and the corresponding
compounding or conversion periods encountered are listed in the table below.

Table 1
Compounding Frequencies and Periods

Compounding or No. of compoundings or Compounding or

Conversion Frequency conversions per year Conversion Periods
Annual 1 1 year
Semiannual 2 6 months
Quarterly 4 3 months
Bimonthly 6 2 months
Monthly 12 1 month

The nominal interest is the stated annual interest rate on which the compound
interest calculation is based. The periodic interest rate is the rate of interest earned in one
conversion period.

The following variables will be used to represent the following:

𝑀 = maturity value of the loan or investment

𝑃 = principal amount of the loan or investment
𝐼 = amount of interest paid or received
𝑗 = nominal interest rate
𝑚 = number of conversions per year
𝑡 = time period of the loan or investment
𝑖 = periodic interest rate
𝑛 = number of conversions of the loan

To determine the maturity value at the end of 𝑛 conversion periods if periodic interest
at the rate 𝑖 is earned each period. The periodic interest 𝑖 is computed by dividing the
𝑗
nominal interest rate by the number of conversion per year (𝑖 = 𝑚). On the other hand,
number of conversions of the loan 𝑛 is the product of time period and number of conversions
per year (𝑛 = 𝑡𝑚).
The derivation of the compound interest formula is shown below. Notice that with
the compound interest, the interest is added to the principal at the end of each conversion
period. A larger principal will be obtained at the beginning of every successive period.

Maturity value (𝑀1 ) after the first period, where P is the principal:

M1 = P + I = P + iP=P(1 + i)

Maturity value (𝑀2 ) after the second period, where (1 + i) or M1 is the new principal:

M2 = [𝑃(1 + i)](1 + i) = P(1 + 𝑖)2

Maturity value (𝑀3 ) after the third period, where P(1 + 𝑖)2 or M2 is the new principal:

M3 = ⌈P(1 + 𝑖)2 ⌉(1 + i) = P(1 + 𝑖)3

KAREN MAE H. PALABRICA

 Mathematics of Finance 4
Simple and Compound Interest

Maturity value (𝑀4 ) after the fourth period, where P(1 + 𝑖)3 or M3 is the new
principal:

M4 = ⌈P(1 + 𝑖)3 ⌉(1 + i) = P(1 + 𝑖)4

After all 𝑛 conversion periods, the maturity value will be:

Mn = ⌈P(1 + 𝑖)𝑛−1 ⌉(1 + i) = P(1 + 𝑖)𝑛 or simply 𝑀 = 𝑃(1 + 𝑖)𝑛

With the use of mathematical manipulation, the following formulas are derived:

𝑀 = 𝑃 (1 + 𝑖 )𝑛 (Formula 2)

𝑀
𝑃= (1+𝑖) 𝑛
(Formula 2.1)

𝐼 = 𝑀−𝑃 (Formula 2.2)

Sample Problem No. 2:

Find the compound amount and compound interest on:
a. ₱7,000.00 for 4 years at 3% compounded annually
b. ₱11,370.00 for 7 years and 3 months at 3% compounded semi-annually

a. Given:
𝑃 = ₱7,000.00
0.03
𝑗 = 3% or 0.03 (m=2) or 𝑖 = 1 = 0.03
𝑛 = (4 years x 1 period per year) = 4

Solutions:
M = P(1 + i)n
= ₱7,000.00(1 + 0.03)4
= ₱7,878.56 (𝑟𝑜𝑢𝑛𝑑𝑒𝑑 𝑡𝑜 𝑡ℎ𝑒 𝑛𝑒𝑎𝑟𝑒𝑠𝑡 𝑐𝑒𝑛𝑡𝑎𝑣𝑜)

I = M−P
= ₱7,878.56 − ₱7,000.00
= ₱878.56

Hence, the compound amount is ₱7,878.56 and the compound interest is ₱878.56.
b. Given:
𝑃 = ₱11,370.00
0.03
𝑗 = 3% or 0.03 (m=2) or 𝑖 = 2 = 0.015
3
𝑛 = (7 12 years x 2 periods per year) = 14.5

Solutions:
M = P(1 + i)n
= ₱11,370.00(1 + 0.015)14.5
= ₱14,109.71 (𝑟𝑜𝑢𝑛𝑑𝑒𝑑 𝑡𝑜 𝑡ℎ𝑒 𝑛𝑒𝑎𝑟𝑒𝑠𝑡 𝑐𝑒𝑛𝑡𝑎𝑣𝑜)
I = M−P

KAREN MAE H. PALABRICA

 Mathematics of Finance 5
Simple and Compound Interest

= ₱14,109.71 − ₱11,370.00
= ₱2,739,71 (𝑟𝑜𝑢𝑛𝑑𝑒𝑑 𝑡𝑜 𝑡ℎ𝑒 𝑛𝑒𝑎𝑟𝑒𝑠𝑡 𝑐𝑒𝑛𝑡𝑎𝑣𝑜)

Hence, the compound amount is ₱14,109.71 and the compound interest is ₱2,739,71

Sample Problem No. 3:

How much must be invested today in a savings account in order to have ₱50,500.00
1
in 6 years and 9 months if money earns 8 % compounded quarterly?
2

Given:
𝑀 = ₱50,500.00
1 0.085
𝑗 = 82% or 0.085 (m=4) or 𝑖 = 4 = 0.02125
9
𝑛 = (612 years x 4 periods per year) = 27

Solution:
P = M(1 + i)−n
= ₱50,500.00 (1 + 0.02125)−27
= ₱28,623.68 (𝑟𝑜𝑢𝑛𝑑𝑒𝑑 𝑡𝑜 𝑡ℎ𝑒 𝑛𝑒𝑎𝑟𝑒𝑠𝑡 𝑐𝑒𝑛𝑡𝑎𝑣𝑜)

Hence, the amount to be invested is ₱28,623.68.

Activity:

Solve the given problems by providing solutions.

1. Brent deposited ₱80,250 in a bank paying 5% simple interest for 4 years. How would he have in
his account at the end of four years assuming that no withdrawals were made?
2. Xien borrowed a certain principal from bank with interest at 7% per annum. After 3.5 years, he
paid back ₱34,500 to the bank for principal plus interest. How much was borrowed?

Exercises:

Read the given scenario and perform the task by answering the guide questions and
investment plan table.

Scenario:
Myla received a cash gift from her parents for her 20th birthday amounting to ₱15,000.
She decided to deposit her money and withdraw it after 5 years in a bank that pays a certain
interest. She immediately looked for a bank that offers good investment. Some of her friends
encouraged her to invest in Bank A while her Aunty suggested Bank B. In order for her to
choose which bank offers better, she created an investment plan.

Bank A Bank B
Year Offer: 3.5% simple interest annually Offer: 2.5% interest compounded annually
Amount of Interest Maturity Value Amount of Interest Maturity Value
1
2
3
4
5

KAREN MAE H. PALABRICA

 Mathematics of Finance 6
Simple and Compound Interest

Guide Questions:

1. How much money will be accumulated in her account after 3 years in Bank A?
2. What is the total amount of the interest gained in Bank B after 4 years?
3. How much interest will she earn in Bank A and Bank B?
4. Which bank offers a better investment plan and why?
5. How many years will it take for ₱15,000 to become ₱25,000 if money is invested in Bank
B?

References:

Winston S. Sirug, P. D. (2016). General Mathematics. Recoletos St. Intramuros, Manila:

Mindshaper Co., Inc.
Zorilla, R. S., Partible, F. G., Bagano, D. C., Bansa, H. E., Cabrera, M. K., & Ganir, F. D. (2016).
General Mathematics for Senior High School. Portrero, Malabon City: Mutya
Publishing House, Inc.
Aufamann, R., Lockwood, J., Nation, R. & Clegg, D. (2008). Mathematical Excursions,
Third Edition. Cengage Learning, Belmont, CA, USA, ISBN-13: 978-1-111-
57849-7, ISBN-10: 1-111-57849-4

KAREN MAE H. PALABRICA