LECTURE 2

INTEREST

ES ECON
Dyanne Brendalyn M. Cavero, MEng
 Time Value of Money
Money has a time value. It has value, and if it
remains uninvested, value is lost.

Money changes in value, not only because of

interest rates, but also inflation (or deflation)
and currency exchange rates.
 Interest

• the charge for the privilege of borrowing

money
• typically expressed as annual percentage
rate (APR)
• refers to the amount of ownership
a stockholder has in a company, usually
expressed as a percentage.
 Interest
Considerations in calculating interest and the amount a
lender will charge a borrower :

• Opportunity cost
• Amount of expected inflation
• Risk that the lender is unable to pay the loan back
because of default
• Length of time that the money is being lent
• Possibility of government intervention on interest rates
• Liquidity of the loan being made
 Interest

Two types :

• Simple interest
• Compound interest
 Simple Interest

• A set rate on the principal originally lent to the

borrower that the borrower has to pay for the
ability to use the money

• A quick method of calculating the interest

charge on a loan.
 Simple Interest

I = PiN

I = interest

P = principal (the amount of money deposited or borrowed)

i = interest rate (percent of the principal earned if paid)

N = time (the length of time the money is deposited or

borrowed)
 Simple Interest
FV = P + I

FV = future value
P = principal
I = simple interest
 Simple Interest

“When you make a payment on a simple interest

loan, the payment first goes toward that
month’s interest, and the remainder goes
toward the principal. Each month’s interest is
paid in full so it never accrues.”
 Simple Interest

An automobile loan that has a $15,000 principal balance

and an annual 5% simple interest rate. If your payment is
due on May 1 and you pay it precisely on the due date,
your interest is calculated on the 30 days in April. Your
interest for 30 days is $61.64 under this scenario.
However, if you make the payment on April 21, the
finance company charges you interest for only for 20 days
in April, dropping your interest payment to $41.09, a $20
savings.
 Exercises
1. Sarah deposits $4,000 at a bank at an interest rate
of 4.5% per year. How much interest will she earn
at the end of 3 years?
2. Wanda borrowed $3,000 from a bank at an
interest rate of 12% per year for a 2-year period.
How much interest does she have to pay the bank
at the end of 2 years?
3. Raymond bought a car for $40, 000. He took a
$20,000 loan from a bank at an interest rate of
15% per year for a 3-year period. What is the total
amount (interest and loan) that he would have to
pay the bank at the end of 3 years?
 Compound Interest
• Interest on both the principal and the compounding
interest paid on that loan

• interest calculated on the initial principal and also on

the accumulated interest of previous periods of
a deposit or loan.

• Can be thought of as “interest on interest” which is

calculated only on the principal amount
 Compound Interest
• The rate at which compound interest accrues depends on
the frequency of compounding;

• the higher the number of compounding periods, the

greater the compound interest.

• Thus, the amount of compound interest accrued on $100

compounded at 10% annually will be lower than that on
$100 compounded at 5% semi-annually over the same
time period.
CI = [P(1+i)n]-P
 Compound Interest
FV = P (1+r/n)nt

FV = future value
P = principal
r = nominal annual interest rate
n = number of times interest is compounded per
year
t = time (years)
 Compound Interest
Example :

If you deposit $4000 into an account paying 6%

annual interest compounded quarterly,
how much money will be in the account
after 5 years?
 Seatwork
1. Determine the ordinary simple interest on P10,000 for 9 months
and 10 days if the rate of interest is 12%.

2. A man borrows P10,000 a loan from a law firm. The rate of simple
interest is 15%, but the interest is to be deducted from the loan at
the time the money is borrowed. At the end of the year, he has to
pay back P10,000. What is the actual interest?

3. If the sum of P12,000 is deposited in an account earning interest

at the rate of 9% compounded quarterly, what will it become at
the end of 10 years?

4. A man possesses a promissory note, due 3 years, hence, whose

maturity value is P6,700.48. If the rate of interest is 10%,
compounded semi-annually, what is the value of the note now?