CHAPTER 1: SIMPLE INTEREST AND SIMPLE DISCOUNT

1.1 Simple interest

1)

Interest is earned on money invested and paid on money borrowed.

2)

Definition of simple interest

Simple interest is the interest due to be paid at the end of the loan is based on the
original principal, the term of the loan and the stated rate of interest.

3)

For these calculations, the following notation shall be used:

P

4)

the principal, or the present value of

SI =

the total simple interest

the future value, or the maturity value, or the accumulated value of P

the rate of interest per period (normally per annum)

the time in periods (normally years)

Simple interest is calculated by this formula:

I Pr t
Amount S :

S P I
S P(1r t )

The factor (1r t )is called the simple interest factor.

5)

We can also express P (present value, PV or the discounted value of S) in terms of S, r

and t:

P
The factor (1r t )
6)

S
(1r t )

is called the present value discount factor.

The time t must be in years when an annual interest rate is used. When the time is given
in months:

num b erof m onths

12

Example 1
Find the simple interest on 90-day loan of $500 at 8.5% p.a.

Example 2
A couple borrows $10000. The interest rate is 1% per month, and the monthly payment is $210.
how much of the first payment goes to interest and how much to reduce the loan?

Example 3
A loan shark made a loan of $100 to be repaid with $120 at the end of one month. What was the
annual rate of simple interest?

Example 4
Eighty days after borrowing money, a person pays back exactly $850. How much was borrowed
if the $850 payment includes principal and simple interest at 9%?

Example 5
How long will it take for $500 to accumulate to at least $560 at 13% simple interest?

The time between dates

In most simple interest calculations it is important to know the exact number of days involved.
We include the day the money is lent (or deposited) but exclude the day the money is repaid (or
withdrawn).
Example 6
Find the number of days between 15 March and 3 September.

Example 7
On 3 November 2001 a woman borrows $500 at 9% p.a. simple interest. The debt is repaid on 8
February 2002. Find the simple interest paid.

1.2 Interest paid on bank balances

Many accounts with banks earn simple interest based on the minimum monthly balance
in the account each month. This means that a deposit and subsequent withdrawal of a
sum of money within the same month will not generate any interest calculation uses the
minimum monthly balances.
Example 1
The following are the transactions in a bank account for a calendar year.

Date

Deposits

Withdrawals

Balance

Opening balance

$200

21 February

$300

$500

3 April

$200

$300

5 June

$600

$900

19 June

$300

$600

2 October

$200

$800

28 October

$400

$400

Calculate the interest due on 3 December if the interest rate is 4% p.a. payable on minimum
monthly balances.

1.3 Present values

Present value using simple interest
In Section 1.1, the present value (or discounted value) of S was calculated by using the
present value factor at simple interest. The interest paid was based on the initial
investment.
Example 1
Calculate the price (or present value) on 3 March of a commercial bill which has a maturity
value of $100 000 on 31 May. Use 6.2% p.a. simple interest

Present value using simple discount

An alternative approach is to use a simple discount rate based on the maturity value of the
commercial bill or investment. That is, the present value or price can be considered to be a
discount (or subtraction) from the maturity value.
Simple discount D, on an amount S, payable in t years, at the annual discount rate d, is
calculated by means of the formula:

D Sd t
and the present value P of S, is given by:

P S D
By substituting for D Sd t , we obtain P in terms of S, d and t:

P S(1d t )

the factor (1d t ) is known as the simple discount factor

Example 2
On 3 May a commercial bill with a maturity date of 30 June and a maturity value of $100 000 is
priced at 5% p.a. simple interest. Calculate:
a)

the amount of the discount;

b)

the price paid.

Example 3
Calculate the present value of $1000 due in 1 year
a)

at a simple interest rate of 10% p.a. and

b)

at a simple discount rate of 10%

c)

It is often desirable to determine the simple interest rate which is equivalent to a given

simple discount rate. A discount rate d and interest r are equivalent if the two rates result in the
same present value P for an amount S due in the future, that is, when we equate the righthand sides of formulas
d)
e)
f)
g)
h)

j)

k)

r
d

Solvi
l) 1
ng
dt
for r: m)
r

i)
s)

Solvin
g for
d:

v)
w)
x)

o)

S(1 S
d t )
p)
r)
1r t
q)

d
u)1r t

Example 4

y)

A bank discounts a sum which is due in 1 year at a simple discount rate of 9% p.a. What

is the equivalent simple interest rate?

z)
aa)
ab)
ac)
ad)
ae)
af)
ag)
1.4 Equations of value
ah)
ai)
1)

financial decisions must take into account the basic idea that money has time value.
That is, the same amount money has different values at different dates. In any financial
transaction involving money due on different dates, every sum of money has an attached
date. As such, mathematics of finance deals with dated values of money or the time
value of money.

aj)
ak)
al)

Example 1
A debt of $1000 is due at the end of 9 months. Find an equivalent debt at a simple

interest rate of 9% p.a. at the end of 4 months and also at the end of 1 year.
am)

an)
ao)
ap)

Example 2

aq)

A person owes $300 due in 3 months and $500 due in 8 months. What single payment a)
now;

ar)

b) in 6 months; and c) in 1 year, will repay these debts if money is worth 8% p.a.

simple interest?
as)
at)
au)
av)
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ba)
bb)
bc)
bd)
be)
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bh)
bi)
2)

One of the most important problems in the mathematics of finance is the replacing of a
given set of payments by an equivalent payment at a particular date.

3)

We say that two sets of payments are equivalent at a given simple interest rate if the
dated values of the sets, on any common date, are equal. An equation stating that the
dated values, on a common date, of two sets of payments are equal is called an
equation of value. The date used is called the focal date or the valuation date.

bj)
bk)
bl)

Example 3
Andrew owes Jane $500 due in 3 months and $200 due in 6 months. If Jane accepts

$300 now, how much will Andrew be required to repay at the end of 1 year, provided they
agree to use a simple interest rate of 10% p.a. and a focal date at the end of 1 year?
bm)
bn)
bo)
bp)
bq)
br)
bs)
bt)

Example 4
A person borrows $1000 at 11% p.a. simple interest. She is to repay the debt with 3

equal payment, the first at the end of 3 months, the second at the end of 6 months and the third
at the end of 9 months. Find the size of the payments. Put the focal date (a) at the present; (b)
at the end of 9 months.
bu)
bv)
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bx)
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1.5 Partial payments
ck)
cl)
1)
Financial debts are sometimes repaid by a series of partial payments during the term of
the loan. It is then necessary to determine the balance due on the final due date.
2)

It is then necessary to determine the balance due on the final due date.

3)

One method to calculate this amount is to allow the entire debt and each partial payment
to earn interest to the final settlement date. The balance due on the final due date is
simply the difference between the accumulated value of the debt and the accumulated
value of the partial payment.

cm)
cn)
co) Example 1
cp)
cq)
cr) On 4 February 1999 a person borrows $3000 at 11% p.a. simple interest. He pays
$1000 on 21 April 1999, $600 on 12 May 1999 and $700 on 11 June 1999. what is the
balance due on 15 August 1999?

1.6 Promissory notes

cs)
ct)
1)

A promissory note is a written promise by a debtor, called the maker of the note, to
pay to, or to the order of, the creditor, called the payee of the note, a sum of money, with
or without interest, on a specified date.

2)

For a promissory note:

cu) its face value is the sum stated in the note;
cv) its due date or maturity date is the date on which the debt is to be
paid; its maturity value is the sum to be paid on the maturity date.

cw)
cx) Example 1
cy) Consider the following promissory note:
cz)
da)
db)

Promissory Note
$2000.00

Sydney, 15 April 2000

Sixty days after date, I promise to pay to the order of Ms A
Two thousand dollars
for value received with simple interest at 12% p.a.

(Signed) Mr B
dc)
dd) On 10 May, Ms A, the holder of the note sells it to a bank, which prices notes at a
simple interest rate of 13% p.a. How much is received for the note?

de)