Simple Interest and Simple Discount

Learning Objectives

Money is invested or borrowed in thousands of transactions every day. When an investment is

cashed in or when borrowed money is repaid, there is a fee that is collected or charged. This fee is called
interest. In this chapter, you will learn how to calculate interest using simple interest. Although most
financial transactions use compound interest, simple interest is still used in many short-term
transactions. Many of the concepts introduced in this chapter are applicable to compound interest. The
chapter starts off with some fundamental relationships for calculating interest and how to determine
the future, or accumulated, value of a single sum of money invested today. You will also learn how to
calculate the time between dates. Section 2 introduces the concept of discounting a future sum of
money to determine its value today. This “present value of a future cash flow” is one of the fundamental
calculations underlying the mathematics of finance. Section 3 in which a less common form of simple
interest — simple discount — is introduced along with the concept of discounted loans. The chapter
ends with section 4, the comparison of Simple and Compound Interest.

Simple Interest
(Section 1)

In any financial transaction, there are two parties involved: an investor, who is lending money to
someone, and a debtor, who is borrowing money from the investor. The debtor must pay back the
money originally borrowed, and also the fee charged for the use of the money, called interest. From the
investor’s point of view, interest is income from invested capital. The capital originally invested in an
interest transaction is called the principal. The sum of the principal and interest due is called the amount
or accumulated value. Any interest transaction can be described by the rate of interest, which is the
ratio of the interest earned in one time unit on the principal.
In early times, the principal lent and the interest paid might be tangible goods (e.g., grain). Now,
they are most commonly in the form of money. The practice of charging interest is as old as the earliest
written records of humanity. Four thousand years ago, the laws of Babylon referred to interest
payments on debts. At simple interest, the interest is computed on the original principal during the
whole time, or term of the loan, at the stated annual rate of interest.

We shall use the following notation:

P = the principal, or the present value of S, or the discounted value of S, or the proceeds.
I = simple interest.
S = the amount, or the accumulated value of P, or the future value of P, or the maturity value of P.
r = annual rate of simple interest.
t = time in years.
Simple interest is calculated by means of the formula

I = Prt

From the definition of the amount S we have:

S=P+I

By substituting for I = Prt, we obtain S in terms of P, r, and t:

S = P + Prt

S = P (1 + rt)

The factor (1 + rt) in formula (2) is called an accumulation factor at

a simple interest rate r and the process of calculating S from P by
formula (2) is called accumulation at a simple interest rate r.

The time t must be in years. When the time is given in months, then: t = number of months 12
When the time is given in days, there are two different varieties of simple interest in use:
1. Exact interest, where: t= numbers of days/365
i.e., the year is taken as 365 days (leap year or not).
2. Ordinary interest, where: t= numbers of days/360
i.e., the year is taken as 360 days.

Discounted Value at Simple Interest

(Section 2)

From formula (2) we can express P in terms of S, r, and t and obtain

S
P= =S ( 1+ rt )-1
1+rt

-1
The factor (1 + rt) in formula (3) is called a discount factor at a simple
interest rate r and the process of calculating P from S is called discounting
at a simple interest rate r, or simple discount at an interest rate r.

When we calculate P from S, we call P the present value of S or the discounted value of S. The difference
D = S − P is called the simple discount on S at an interest rate
 For a given interest rate r, the difference S − P has two interpretations.
1. The interest I on P which when added to P gives S.
2. The discount D on S which when subtracted from S gives P.

Simple Discount at a Discount Rate

(Section 3)

The calculation of present (or discounted) value over durations of less than one year is
sometimes based on a simple discount rate. The annual simple discount rate d is the ratio of the
discount D for the year to the amount S on which the discount is given. The simple discount D on an
amount S for t years at the discount rate d is calculated by means of the formula:

D = Sdt

And the discounted value P of S, or the proceeds P, is given by

P=S−D
By substituting for D = Sdt we obtain P in terms of S, d, and t
P = S − Sdt

P = S(1 − dt)

The factor (1 − dt) in formula (5) is called a discount factor at a

simple discount rate d.

Simple discount is not very common. However, it should not be ignored. Some financial
institutions offer what are referred to as discounted loans. For these types of loans, the interest charge
is based on the final amount, S, rather than on the present value. The lender calculates the interest
(which is called discount) D, using formula (4) and deducts this amount from S. The difference, P, is the
amount the borrower actually receives, even though the actual loan amount is considered to be S. The
borrower pays back S on the due date. For this reason the interest charge on discounted loans is
sometimes referred to as interest in advance, as the interest is paid up front, at the time of the loan,
instead of the more common practice of paying interest on the final due date.
In theory, we can also accumulate a sum of money using simple discount, although it is not
commonly done in practice. From formula (5), we can express S in terms of P, d, and t and obtain

P
S= =P ( 1−dt )
1−dt
-1
The factor (1 − dt) in formula (6) is called an accumulation factor at a
simple discount rate d.
 Formula (6) can be used to calculate the maturity value of a loan for specified proceeds.

Simple Interest vs. Compound Interest

(Section 4)

Interest is defined as the cost of borrowing money as in the case of interest charged on a loan
balance. Conversely, interest can also be the rate paid for money on deposit as in the case of a
certificate of deposit. Interest can be calculated in two ways, simple interest or compound interest.

Simple interest is calculated on the principal, or original, amount of a loan.

Compound interest is calculated on the principal amount and also on the accumulated interest of
previous periods, and can thus be regarded as "interest on interest."

There are some significant differences between simple and compound interest:
 Simple interest is easier to calculate.

 Simple interest is always the same amount since it is a percentage of the principle. The
compound interest amount will be different every accrual period since it is a percentage of the
principal plus interest earned or accrued to date.

 The principal remains the same with simple interest. With compound interest, the compounded
interest is added to the principal, increasing the principal amount.

 Since the interest charge and principal amount are the same every accrual period with a simple
interest loan, you won't be charged for outstanding interest when you pay the loan off.

 Simple interest is better for purchases such as car loans since the cost of the loan is static.
Compound interest is better for investing or saving since your funds will grow quicker.

There can be a big difference in the amount of interest payable on a loan if interest is calculated
on a compound rather than simple basis. On the positive side, the magic of compounding can work to
your advantage when it comes to your investments and can be a potent factor in wealth creation.
While simple interest and compound interest are basic financial concepts, becoming thoroughly familiar
with them may help you make more informed decisions when taking out a loan or investing.