Simple and Compound

Interest

Interest is the fee paid for borrowed money. We receive

interest when we let others use our money (for example, by
depositing money in a savings account or making a loan).
We pay interest when we use other people’s money (such
8
as when we borrow from a bank or a friend). Are you a
“receiver” or a “payer”?
In this chapter we will study simple and compound
interest. Simple interest is interest that is calculated on
the balance owed but not on previous interest. Compound
interest, on the other hand, is interest calculated on any
balance owed including previous interest. Interest for loans
is generally calculated using simple interest, while interest
for savings accounts is generally calculated using com-
pound interest.
The concepts of this chapter are used in many upcom-
ing topics of the text. So hopefully you have interest in mas-
tering the stuff in this chapter.

UNIT OBJECTIVES
Unit 8.1 Computing simple interest and Unit 8.2 Solving for principal, rate, and time
maturity value
●
a Solving for P (principal) and T (time)
●
a Computing simple interest and maturity value— ●
b Solving for R (rate)
loans stated in months or years
●
b Counting days and determining maturity date— Unit 8.3 Compound interest
loans stated in days
●
c Computing simple interest—loans stated in days ●
a Understanding how compound interest differs from
simple interest
●
b Computing compound interest for different com-
pounding periods

151
Unit 8.1 Computing simple interest and maturity value
Wendy Chapman just graduated from college with
a degree in accounting and decided to open her
own accounting office (she can finally start earning
money instead of paying it on college). On July 10,
2005, Wendy borrowed $12,000 from her Aunt
Nelda for office furniture and other start-up costs.
She agreed to repay Aunt Nelda in 1 year, together
with interest at 9%.
The original amount Wendy borrowed—
$12,000—is the principal. The percent that
Wendy pays for the use of the money—9%—is the
rate of interest (or simply the interest rate). The
length of time—1 year—is called the time or
term. The date on which the loan is to be repaid—
Banks provide a valuable service as money bro-
July 10, 2006—is called the due date or maturity kers. They borrow from some people (through
date. The total amount Wendy must repay (which savings accounts, etc.) and loan that same
we will calculate later) consists of principal money to others (at a higher rate). Some of
($12,000) and interest ($1,080); the total amount these loans are simple interest loans.
($13,080) is called the maturity value.

●
a Computing simple interest and maturity value—loans stated in months or years
To calculate interest, we first multiply the principal by the annual rate of interest; this gives us inter-
est per year. We then multiply the result by time (in years).

= s i m p l e i n t e re s t f o r m u l a

I = PRT
I = Dollar amount of interest P = Principal R = Annual rate of interest T = Time (in years)

TIP what is PRT?

Remember, when symbols are written side by side, it means to multiply, so PRT means P × R × T. Also,
don’t forget R, the interest rate, is the annual rate; and T is expressed in years (or a fraction of a year).

Example 1 On July 10, 2005, Wendy Chapman borrowed $12,000 from her Aunt Nelda. If Wendy agreed to
pay a 9% annual rate of interest, calculate the dollar amount of interest she must pay if the loan is
for (a) 1 year, (b) 5 months, and (c) 15 months.
____________

a. 1 year: I = PRT = $12,000 × 9% × 1 = $1,080

b. 5 months: I = PRT = $12,000 × 9% × 12
5 = $450

c. 15 months: I = PRT = $12,000 × 9% × 12

15 = $1,350

We can do the arithmetic of Example 1 with a calculator:

Key s t ro ke s ( f o r m o s t c a l c u l a t o r s )

12,000 × 9 % = 1,080.00
12,000 × 9 % × 5 ÷ 12 = 450.00
12,000 × 9 % × 15 ÷ 12 = 1,350.00

152 Chapter 8 Simple and Compound Interest

 To find the maturity value, we simply add interest to the principal.

= maturity value formula

M=P+I
M = Maturity value P = Principal I = Dollar amount of interest

Example 2 Refer to Example 1. Calculate the maturity value if the 9% $12,000 loan is for (a) 1 year, (b) 5
months, and (c) 15 months.
____________
a. 1 year: M = P + I = $12,000 + $1,080 = $13,080
b. 5 months: M = P + I = $12,000 + $450 = $12,450
c. 15 months: M = P + I = $12,000 + $1,350 = $13,350

Wendy must pay a total of $13,080 if the loan is repaid in 1 year (July 10, 2006), $12,450 if the loan
is repaid in 5 months (December 10, 2005), and $13,350 if the loan is repaid in 15 months (October
10, 2006).

●
b Counting days and determining maturity date—loans stated in days
In Examples 1 and 2, the term was stated in months or years. Short-term bank loans often have a
term stated in days (such as 90 or 180 days) rather than months. Before calculating the amount of
interest for these loans, we must know how to count days. One method is to look at a regular calen-
dar and start counting: the day after the date of the loan is day 1, and so on. However, that method
can be time-consuming and it is easy to make a mistake along the way. We will, instead, use a day-
of-the-year calendar, shown as Appendix D; pay special attention to the entertaining footnote. In the
day-of-the-year calendar, each day is numbered; for example, July 10 is day 191 (it is the 191st day
of the year). The next example shows how to use a day-of-the-year calendar.

Example 3 Find (a) 90 days from September 10, 2006; (b) 180 days from September 10, 2006; and (c) 180
days from September 10, 2007.
____________
a. Sep. 10 → Day 253
+90
Dec. 9 ← 343

b. Sep. 10 → Day 253

+180
433 (This is greater than 365, so we must subtract 365)
- 365
Mar. 9 ← 68

c. Sep. 10 → Day 253

+180
433 (This is greater than 365, so we must subtract 365)
- 365
Mar. 8 ← 68 (Because this is a leap year, March 8 is day 68)

In parts (b) and (c) of Example 3, we found that the final date was the 68th day of the year. For
a non-leap year, the 68th day is March 9. With a leap year, like 2008, there is an extra day in February
so March 9 is day 69; March 8 is day number 68.
An optional method for counting days is known as the days-in-a-month method. With this
method, we remember how many days there are in each month; the method is shown in Appendix
D, page D-2. While a day-of-the-year calendar is often easier to use, understanding the days-in-a-
month method is important because we may not always have a day-of-the-year calendar with us.
Here is how we could do Example 3, part (c), using the days-in-a-month method:

Unit 8.1 Computing simple interest and maturity value 153

 180 days from September 10, 2007?
Days left in September: 30 - 10 = 20 September has 30 days; not charged interest for first 10 days
Days in October + 31
Subtotal 51
Days in November + 30
Subtotal 81
Days in December + 31
Subtotal 112
Days in January + 31
Subtotal 143
Days in February (leap year) + 29
Subtotal 172
Days in March + 8 We need 8 more days to total 180
Total 180
Date is March 8

In the next example, we’ll figure out how many days between two dates. For some of us, there
are quite a few days between dates (oops, wrong kind of date).

Example 4 Find the number of days between each set of dates: (a) July 24 to November 22, (b) July 24 to March
13 of the following year (non-leap year), and (c) July 24 to March 13 (leap year).
____________
a. Nov. 22 → Day 326 (Last day is minuend, on top)
July 24 → Day -205
121 days

b. Number of days left in first year: 365 - 205 (day number for July 24) 160
Number of days in next year: Mar. 13 → +72
232 days

c. Number of days left in first year: 365 - 205 (day number for July 24) 160
Number of days in next year: Mar. 13 → 72 + 1 (for leap year) → +73
233 days

In part (b) of Example 4 (non-leap year), March 13 is day 72. But with a leap year in part (c),
there is an extra day in February, making March 13 day 73, not day 72.
Here is how we could do Example 4, part (c), using the days-in-a-month method:

Days between July 24 and March 13 (a leap year)?

Days in July: 31 - 24 = 7 July has 31 days; not charged interest for first 24 days
Days in August 31
Days in September 30
Days in October 31
Days in November 30
Days in December 31
Days in January 31
Days in February (leap year) 29
Days in March + 13
Total 233 days

154 Chapter 8 Simple and Compound Interest

●
c Computing simple interest—loans stated in days

The Truth in Lending Act, also known as Regulation Z, applies to consumer loans. The regulation
does not set maximum interest rates; however many states set limits. It does require lenders to notify
the borrower of two things: how much extra money the borrower is paying (known as finance
charges) as a result of borrowing the money and the annual percentage rate (APR) the borrower is
paying, accurate to 18 of 1%. The law does not apply to business loans, loans over $25,000 (unless
they are secured by real estate), most public utility fees, and student loan programs. Apparently, the
government figures that businesspeople and—get this—students are bright enough to figure their
own APR.
Prior to 1969, when the Truth in Lending Act became effective, lenders generally used a 360-
day year for calculating interest. Without calculators and computers, calculations were easier using a
360-day year than a 365-day year. In calculating an APR for Truth in Lending purposes, lenders are
required to use a 365-day year. Many lenders use a 360-day year for business loans (remember, busi-
ness loans are exempt from the Truth in Lending Act).
Although we will not emphasize the following terminology, some people and some textbooks
refer to interest based on a 360-day year as ordinary interest (or banker’s interest) and interest
based on a 365-day year as exact interest.

Example 5 Calculate interest on a 90-day $5,000 loan at 11%, using (a) a 360-day year and (b) a 365-day year.
____________
a. 90 = $137.50
360-day year: I = PRT = $5,000 × 11% × 360
90
b. 365-day year: I = PRT = $5,000 × 11% × 365 = $135.62

As you can see from Example 5, a 360-day year benefits the lender and a 365-day year benefits
the borrower.

TIP use estimating to determine if an answer is reasonable

It is easy to make a mistake when lengthy calculations are involved (none of us ever makes mis-
takes though, do we?). Estimating can be helpful in detecting errors. Using a rate of 10% and a term
of 1 year provides a good reference point to estimate interest. In Example 5, $5,000 × 10% inter-
est for 1 year is $500 (we simply move the decimal point one place to the left). The loan of Example
5 is for about 41 of a year; 41 of $500 is about $125. And the rate is 11%, not 10%, so the amount
would be slightly greater than $125. The two answers of Example 5, $137.50 and $135.62,
seem reasonable.

While some loan agreements require the borrower to pay a prepayment penalty if the loan is paid
off early, most loans give the borrower the right to prepay part or all of the loan without penalty. Most
lenders rely on what is called the U.S. Rule to calculate interest. With the U.S. Rule, interest is cal-
culated to the date payment is received and on the basis of a 365-day year.

Example 6 Refer to Example 5, in which you get a 90-day $5,000 loan at 11%. You are able to pay the loan off
early, in 65 days. Calculate interest using the U.S. Rule.
____________
65 = $97.95
I = PRT = $5,000 × 11% × 365

Interest is $97.95. You saved $37.67 ($135.62 - $97.95) by paying off the loan early.

Unit 8.1 Computing simple interest and maturity value 155

 When a borrower elects to repay a single-payment loan with partial payments, interest is calcu-
lated first; the remainder of each partial payment is treated as principal and reduces the loan balance.

p a r t i a l p ay m e n t s : c a l c u l a t i n g i n t e re s t ,
p r i n c i p a l , a n d re m a i n i n g b a l a n c e
Step 1 Calculate interest: I = PRT
Step 2 The remainder of the payment is principal: Principal = Total paid - Interest portion
Step 3 New balance = Previous balance - Principal portion of payment
Note: For the final payment, principal is the previous balance (so the balance will end up zero).

Example 7 Refer to Example 6, in which you get a 90-day $5,000 loan at 11% interest. Suppose you have some
extra cash and pay $2,000 on day 21 (21 days after getting the loan); on day 65 (65 days after get-
ting the loan) you pay off the loan. Calculate the amount of interest and principal for each payment
as well as the total amount of your final payment.
____________

Day number Total payment Interest Principal Balance

0 — — — $5,000.00
21 $2,000.00 $31.64 $1,968.36 $3,031.64
65 $3,071.84 $40.20 $3,031.64 $ 0.00
Totals $5,071.84 $71.84 $5,000.00 —

Procedure for payment on day 21

21 = $31.64
I = PRT = $5,000.00 × 11% × 365
Principal = $2,000.00 - $31.64 = $1,968.36
Balance = $5,000.00 - $1,968.36 = $3,031.64

Procedure for payment on day 65

44 = $40.20 (65 days - 21 days = 44 days)
I = PRT = $3,031.64 × 11% × 365
Principal = $3,031.64 (previous balance, so balance will be $0.00)
Total payment = $40.20 interest + $3,031.64 principal = $3,071.84

TIP double the interest

In Example 7, when calculating interest for the payment on day 65, you may have been tempted to
calculate interest for 65 days. Remember, however, we calculated interest for the first 21 days as
part of the first payment; you don’t want to be charged interest again for the first 21 days (once is
enough!).

Notice that in Example 7 you paid total interest of $71.84 compared to interest of $97.95 in Example
6. You may wonder why you saved some interest since both loans were paid off on day 65. The rea-
son is that by paying $2,000 on day 21, the balance decreased, and interest for the last 44 days was
figured on that reduced balance.
Well, that does it for this unit. Let’s do the U-Try-It exercises to see if you understand the prin-
cipal points of this unit. Take your time; do the problems at your own rate.

1. Suppose you borrow $8,000 for 18 months at 11% simple interest. Find: (a) interest and
U-Try-It (b) maturity value.
(Unit 8.1) 2. Find 180 days from August 5.
3. How many days are there between May 22 and October 14?
4. You get a 90-day $15,000 business loan from your bank at 9.25% interest. Calculate interest
assuming the bank uses (a) a 365-day year and (b) a 360-day year.

156 Chapter 8 Simple and Compound Interest

 5. You get a 180-day $20,000 loan from your credit union at 10.5% interest. You have some extra
cash and pay $8,000 on day 40 (40 days after getting the loan); on day 115 (115 days after get-
ting the loan) you pay off the loan. Find the missing numbers (use a 365-day year).

Day number Total payment Interest Principal Balance

0 — — — $20,000.00
40 $8,000.00
115
Totals —
____________
Answers: (If you have a different answer, check the solution in Appendix A.)
1a. $1,320 1b. $9,320 2. Feb. 1 3. 145 days 4a. $342.12 4b. $346.88 5. Payment on day 40: $230.14, $7,769.86,
$12,230.14. Payment on day 115: $12,494.01, $263.87, $12,230.14, $0.00 Totals: $20,494.01, $494.01, $20,000.00

Unit 8.2 Solving for principal, rate, and time

In Unit 8.1, we used the simple interest formula I = PRT to solve for I. We can also solve for the other
variables (P, R, and T). It will be easier if we have a formula especially designed for the variable in
question. We can create separate formulas by using the Golden Rule of Equation Solving: Do unto one
side as you do unto the other. For example, to find P, we can divide both sides of the formula
I = P. Or, we can use the following memory aid:
I = PRT by RT, getting RT

TIP memor y aid

As a memory aid, some people like to place the symbols I, P, R, and T in a circle (notice that the I
is alone at the top). The formula for each of the variables is found by covering the appropriate
letter. Covering P with your finger, for example, shows I over RT.

I = PRT
I
I
P = RT I
R = PT I
T = PR
P R T
I = Dollar amount of interest P = Principal
R = Annual rate of interest T = Time (in years)

Now we will solve a few problems for the variables P, R, and T. Because there are many more appli-
cations in solving for R than for P and T, we will solve for R last.

●
a Solving for P (principal) and T (time)

Example 1 You open a checking account. You are paid 3% interest on the average balance but are charged a $5
monthly charge. Assuming that interest is paid monthly (regardless of the number of days in the
month), calculate the average balance you must maintain to offset the $5 monthly charge.
____________

I P= I = $5 = $5 = $5 = $2,000
($5) RT 3% × 1 .03 × 1 ÷ 12 .0025
12
P R T
(?) (3%) (121 ) 1 = $5.00
Check answer: I = PRT = $2000 × 3% × 12

You must maintain an average balance of $2,000.

Unit 8.2 Solving for principal, rate, and time 157

 Example 2 You decide to pay off an 8% $5,000 loan early. The bank tells you that you owe a total of $82.19
interest. Assuming that the bank uses a 365-day year, for how many days are you being charged interest?
____________
Remember, when we solve for T, we are finding the portion of a year, not the number of days.

I
($82.19)
T = I = $82.19 = $82.19 = .205475
P R T PR $5,000 × 8% $400.00
($5,000) (8%) (?)

You are being charged for .205475 of a year. Because there are 365 days in a year:
75
365 days × .205475 = 75 days. Check answer: I = PRT = $5,000 × 8% × 365 = $82.19
You are being charged interest for 75 days.

●
b Solving for R (rate)
Now we will solve for R. Remember, R can be considered to be an APR (annual percentage rate).

Example 3 You borrow $500 from your uncle and agree to repay the $500 plus $20 interest in 6 months.
What interest rate are you paying?
____________

I
($20)
R = I = $20
6
= $20 = .08 = 8%
P R T PT $500 × 12 $250
($500) (?) (126 )

You are paying an annual rate of 8%.

The Truth in Lending Act requires lenders to treat certain loan fees (such as credit report fees or
“set-up” fees) as finance charges for purposes of calculating an APR. This is consistent with the con-
cept that an APR considers the “amount and timing of value received and the amount and timing of
payments made.”

Example 4 You get a 90-day $3,000 consumer loan at 8%. You are required to pay a document preparation fee
of $50. Calculate your APR. Express the rate with two decimal places.
____________
• Principal (P) for APR purposes is the amount of money you have use of: $3,000 - $50 fee = $2,950
• Interest (I) for APR purposes is total finance charges:
90
I = PRT = $3,000 × 8% × 365 = $ 59.18
Document preparation fee + 50.00
Total finance charges $109.18

R = I = $109.18 = $109.18 ~ .1501 ~ 15.01%

90 ~ ~
PT $2,950 × 365 $727.40
←

The symbol ~ means “approximately equal to”

You are really paying an annual rate (APR) of 15.01%, considerably higher than the 8% stated rate.
Because the loan is a consumer loan, the lender must inform you in writing what the APR is before
you sign the loan agreement.
Suppose, instead of getting the loan in Example 4, you can get a 12% loan with no fees. You
would be better off getting the 12% loan, since the APR is only 12%, while the APR for the loan in
Example 4 is 15.01%.
Some lenders use a 360-day year for business loans. In the next example, we will calculate an
APR on a loan using a 360-day year.

158 Chapter 8 Simple and Compound Interest

 Example 5 You get a 60-day $2,000 business loan at 10% interest. The lender uses a 360-day year. Calculate
your APR.
____________
60 = $33.33
I = PRT = $2000 × 10% × 360

R= I = $33.33
60
= $33.33 ~~ .1014 ~
~ 10.14%
PT $2,000 × 365 $328.77

←
Even if interest is calculated using a 360-day year, an APR always uses a 365-day year

You must pay $33.33 interest. You are really paying an annual rate (APR) of 10.14%. Because the loan
is a business loan (not a consumer loan), the lender is not required to inform you of the APR. But
that’s no problem because you can calculate your own APR (right?).

Another way to calculate interest is known as the discount method (also referred to as the bank
discount method). This method, not used as much now as in the past, figures interest on the matu-
rity value; the proceeds (maturity value minus interest) are given to the borrower, who must repay
the maturity value. The bank discount method uses a 360-day year.

= bank discount method formulas

D = MRT
Proceeds = M - D
D = Bank discount (dollar amount of interest) R = Annual rate
M = Maturity value T = Time, in years (using a 360-day year)

Example 6 You get a loan using the discount method. You sign a note, agreeing to repay the lender $5,000 in 90
days. Assuming a discount rate of 12%, calculate (a) interest (discount), (b) proceeds you receive,
and (c) the APR.
____________
90 = $150
a. D = MRT = $5,000 × 12% × 360

b. Proceeds = M - D = $5,000 - $150 = $4,850

c. APR: R = I = $150
90
= $150 ~ ~ .1254 ~
~ 12.54%
PT $4,850 × 365 $1,195.89
←

This is the amount of money you have use of

You will be given $4,850 and must pay back $5,000 in 90 days, resulting in an APR of 12.54%.

In Example 6, the APR (12.54%) is higher than the discount rate (12%). This is due to two fac-
tors: (1) interest for the loan of Example 6 is calculated on the maturity value ($5,000), rather than
the amount you have use of ($4,850), and (2) the discount method uses a 360-day year, whereas the
APR always uses a 365-day year.
That does it for this unit. Let’s try the U-Try-It set to find out if it sunk in!

1. You pay your bank $157.50 interest for 6 months on a 9% loan. How much did you borrow?
U-Try-It 2. You pay your bank $78.90 interest on an 8% $4,000 loan. If the bank uses a 365-day year, for
(Unit 8.2) how many days are you being charged interest?
3. You get a $5,000 business loan for 180 days at 10.5% interest. The lender charges you a $150
document preparation fee and uses a 360-day year for calculating interest. What is your APR, to
the nearest hundredth of a percent?
____________
Answers: (If you have a different answer, check the solution in Appendix A.)
1. $3,500 2. 90 days 3. 17.25%

Unit 8.2 Solving for principal, rate, and time 159