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Financial
Mathematics /
Simple Interest
Rate &
Compounding
10Maths Essential
ST1W3 Thursday
19th Feb 2015

Lesson Plan 4_10Math Essential_Simple and Compounding Interest Rate dd 19.02.15.nb

Prerequisite
Understand number set N, Z, and Q.
Have basic knowledge of percentage and its calculations with other numbers.
Be able to do arithmetic of numbers from different number sets including the addition,
subtraction, multiplication, division and exponentiation and log if possible

Lesson Plan 4_10Math Essential_Simple and Compounding Interest Rate dd 19.02.15.nb

Learning Objectives
Understand the definition of simple interest rate, compounding Interest Rate, effective interest
rate.
Give explicit explanation of the main formulas that are used in the calculation of A, P, R, T, n.
Fully explain how to solve one variable given the rest are known for a formula.
Give full explanation of the formulae derivation.
Follow guidelines in choosing the appropriate financial products using effective interest rate.

Definitions
Unit of Simple Interest Rate R % p.a.
R is measured by % p.a.
All interest rates incl. simple, compounding and effective (Ref) has to be measured by % per
annum,
If the interest rate r is not stated as % p.a. such as 2.0% for a month (t: represent the
investment period, can be daily, monthly, quarterly, half yearly) penalty rate for credit card,
then we have to convert it to the annual interest rate % p.a by two ways:

R
1 Yr
= t
r

R=rx

1 Yr
=
t

2.0% x

12 mths
=
1 mth

24% p.a.

Use Ref formula (explained later)

DefN of Simple Interest Rate R % p.a.

It is the price of money
R is the rate quoted in loan and deposit agreements.
R = 7% p.a. is composed of 3 components:

%=+
+
=%+%+%

Lesson Plan 4_10Math Essential_Simple and Compounding Interest Rate dd 19.02.15.nb

Definition cont.
Compounding refers to generate earnings from previous earnings that is to say capitalise the
interest on top of the initial principal and revinvest total amount A for next investment term.
R % p.a. can be compounded n times a year, n represents the compounding frequency in a year
n = 1, compounding yearly
n = 2, compounding half yearly
n = 4, compounding quarterly
n = 12, compounding monthly
n = 365, compounding daily
n = + , continuously compounding
Effective rate Ref % p.a.
DefN of Effective rate Ref % p.a. for compounding is the Equivalent simple interest
rate that would yield the same return for 1 year.
Ref R
Ref = R, no compounding
Ref > R, compounding
nR

Formulae
For associated mathematical formulae:
Accuracy: all symbols has accurate denotation and unit
Consistent: different symbols have different denotation and same symbol in different
formulae represent the same unit
Logical: Each symobl represents a variable, some variables are related. We only care about
the numbers of the independent (unrelated) variables
if the formula has x indep. variables, to solve any 1 variable, we need to know (x-1) indep. variables.
Otherwise, we have to set up more functions to solve additional indep. variables before we can solve
the one requested in the question

Formulae: I = PRT; A = P + I
Total Repayment: A = P + I
A: total repayment at the end of investment term $
P: initial principal $
I: Interest that earned $

Lesson Plan 4_10Math Essential_Simple and Compounding Interest Rate dd 19.02.15.nb

Simple Interest I = PRT;

I: Interest that earned $
P: Initial principal $
R: Simple Interest Rate %
T: total investment term, measured by the proportion of 1 yr or multiples of
In all financial calc, we have to convert term T from other units such as months, days,
hours, minutes etc into years
E.g. 1 year i.e 0.75 yrs = 9 months; 1.5 yrs = 18 months
eg 1. Tom saved $5000 last year and he decides to invest it for a term deposit for 3 months with
an interest rate 4.5%. What is the total repayment after 3 months?
P, I, R, T know solve A

eg2. Tom saved $5000 last year and he plans to invest it for a term deposit with an interest rate
of 4.2%. His goal is to reach $6000 in total. What is the minimum investment term T ?
P, R, A solve T

eg3. Tom has a total repayment of $7000 from the bank term deposit of his savings.He save his
money for 6 months at the interest rate of 5.2%. How much money did Tom save in the bank 6
months ago? and how much interest that Tom earned?
A, T, R solve P and I

Lesson Plan 4_10Math Essential_Simple and Compounding Interest Rate dd 19.02.15.nb

Formulae: A =P 1 +

R nT

Solve Compounding Interest $ two steps 1) A =P 1 +

R nT
; 2)
n

I=A-P

Recall associated maths formulae have to be accurate, consistent and logic.

A: total repayment at the end of investment term $
P: initial principal $
R: Simple Interest Rate %
n: the compounding frequency # in a year
I: Interest that earned $
T: totay investment term, measured by yrs

For compounding, A =P 1 +

R nT

Why ? Formula Derivation

Tom invested his saving P for a term deposit for T years with Interest Rate R compounded n times a year. What is the total
repayment A after maturity of the term deposit?
Set up:

Given by the DefN of compounding that interest earned in the ith term is capitalised on top of P i-1 , so the new princi-

pal Pi for (i+1)th term is the sum of Pi-1 and Ii . Each term i has the same length of time, i = 1, 2, 3, .....nT. Hence we have below
equation:
P i = Ai
Ii

= Pi-1+ Ii

= Pi-1 R n1

P0 = P ;
PnT

= AnT =

Mathematical Deduction:
Let i=1, at the end of the 1st term :

P1

A1= P0+ I1= P+ PR

P 1 +

R 1

Let i=2, at the end of the 2nd term :

P2

A2= P1+ I2= P 1 +

R
+ P 1 + Rn R n1
n

= P (1 + Rn (1 + Rn = P 1 +

Let i=3, at the end of the 3rd term :

P3

A3 = P 2 + I 3 =

P 1 +

=P 1 +

R 2
+P
n
R 3

1 +

R 2
R n1 =
n

(1 + Rn

... ...
Let i=nT, at the end of the nTth term :
PnT

=
=

AnT = A

P(nT -1)+ InT =

( -)

(1 + Rn

R nT

n
R nT

= P 1 +
= P 1 +

A =P 1 +

P 1 +

R nT

proved.

R (nT -1)

+P
n

1 +

R (nT -1)
1

R
n
n

R 2

Lesson Plan 4_10Math Essential_Simple and Compounding Interest Rate dd 19.02.15.nb

=(-)+

= +

= +

=(-)

(-)

Formulae: Ref
DefN of Effective rate Ref % p.a. : Ref for compounding is the equivalent simple interest rate
that yields the same return for the same investment in a year.
Formula Ref = [ 1 +
Why Ref = [ 1 +

R n
n

R n
n

1] 100 %

1] 100 %? Prove.

Tom invested his saving P for a term deposit for 1 years with Interest Rate R compounded n times a year. What is the total
repayment Ref of his investment?
Proof of the formula Ref = [

1 +

R n
n

1] 100 %? comes from the defN that states the effective rate Ref % p.a. is 1) the

equivalent simple interest rate that 2) yeilds the same return for the same investment 3) in a year.
Prove: we know from compounding formula that

A =P 1 +

R nT

Let T = 1, ------------------ 3)

A =P 1 +

R n

Let R be the Simple Interest rate that will yield the same return of Toms investment of his savings, so by DefN of Ref, we have:
Ref = R ------------ 1)
Let I be the interest that tom earned in a year of his investment, Then we can get I:
I=A-P=P

1 +

R n

-P

According to the formula of simple interest:

Lesson Plan 4_10Math Essential_Simple and Compounding Interest Rate dd 19.02.15.nb

I = PRT R =

I
PT

I
= PI
Px1

Ref = R = PI -------------2) =
=1 +

R n
n

R n

P 1+ n -P
p

1] 100 %

Ref = 1 +

R n
n

1] 100 % proved.

Summary
Simple Interest I = PRT
A=P+II=A-PP=A-I
R = Ref =
A =P 1 +

I
p 100 %
R nT

Ref = [ 1 +

= 1 +

R n
n

1] 100 %

R n
n

1=1 +

R n
n

1] 100

1
100