Simple Interest

Discussing interest starts with the principal, or amount your account starts with. This could be a starting investment, or the starting amount of a loan. Interest, in its most simple form, is calculated as a percent of the principal. For example, if you borrowed $100 from a friend and agree to repay it with 5% interest, then the amount of interest you would pay would just be 5% of 100: $100(0.05) = $5. The total amount you would repay would be $105, the original principal plus the interest.

Simple One-time Interest

[latex]\begin{align}&;;I={{P}_{0}}r\\&;;A={{P}_{0}}+I={{P}_{0}}+{{P}_{0}}r={{P}_{0}}(1+r)\\\end{align}[/latex]

I is the interest

A is the end amount: principal plus interest

P0 is the principal (starting amount)

r is the interest rate (in decimal form. Example: 5% = 0.05)

Example 1

A friend asks to borrow $300 and agrees to repay it in 30 days with 3% interest. How much interest will you earn?

P0 = $300                    the principal

r = 0.03                      3% rate

I = $300(0.03) = $9.   You will earn $9 interest.

One-time simple interest is only common for extremely short-term loans. For longer term loans, it is common for interest to be paid on a daily, monthly, quarterly, or annual basis. In that case, interest would be earned regularly. For example, bonds are essentially a loan made to the bond issuer (a company or government) by you, the bond holder. In return for the loan, the issuer agrees to pay interest, often annually. Bonds have a maturity date, at which time the issuer pays back the original bond value.

Example 2

Suppose your city is building a new park, and issues bonds to raise the money to build it. You obtain a $1,000 bond that pays 5% interest annually that matures in 5 years.   How much interest will you earn?

Each year, you would earn 5% interest: $1000(0.05) = $50 in interest. So over the course of five years, you would earn a total of $250 in interest. When the bond matures, you would receive back the $1,000 you originally paid, leaving you with a total of $1,250.

We can generalize this idea of simple interest over time.

Simple Interest over Time

[latex]\begin{align}&I={{P}_{0}}rt\\&A={{P}_{0}}+I={{P}_{0}}+{{P}_{0}}rt={{P}_{0}}(1+rt)\\\end{align}[/latex]

I is the interest

A is the end amount: principal plus interest

P0 is the principal (starting amount)

r is the interest rate in decimal form

t is time

The units of measurement (years, months, etc.) for the time should match the time period for the interest rate.

APR – Annual Percentage Rate

Interest rates are usually given as an annual percentage rate (APR) – the total interest that will be paid in the year. If the interest is paid in smaller time increments, the APR will be divided up.

For example, a 6% APR paid monthly would be divided into twelve 0.5% payments.

A 4% annual rate paid quarterly would be divided into four 1% payments.

Example 3

Treasury Notes (T-notes) are bonds issued by the federal government to cover its expenses. Suppose you obtain a $1,000 T-note with a 4% annual rate, paid semi-annually, with a maturity in 4 years. How much interest will you earn?

Since interest is being paid semi-annually (twice a year), the 4% interest will be divided into two 2% payments.

P0 = $1000                  the principal

r = 0.02                      2% rate per half-year

t = 8                            4 years = 8 half-years

I = $1000(0.02)(8) = $160.   You will earn $160 interest total over the four years.

Try it Now 1

A loan company charges $30 interest for a one month loan of $500. Find the annual interest rate they are charging.