Math 141 Lecture Notes: Section 5.1 Compound Interest

Math 141 Lecture Notes
Section 5.1 Compound Interest
Simple Interest
I = Prt, where I is the interest, P is the principal, r is the interest rate, and t is the time in
years.
A = P(1 + rt), where A is the accumulated amount, P is the principal, r is the interest rate,
and t is the time in years.
Example 1: A bank pays simple interest at the rate of 7% per year for certain deposits.
If a customer deposits $1000 and makes no withdrawals for 3 years, what is the total
amount on deposit at the end of 3 years? What is the interest earned in that period of
time?
Example 2: An amount of $2000 is invested in a 15-year trust fund that pays 6.5%
annual simple interest. What is the total amount of the trust fund at the end of 15 years?
Compound Interest
Earned interest that is periodically added to the principal and thereafter itself earns
interest at the same rate is called compound interest.
nt
 r
A  P1   , where A is the accumulated amount, P is the principal, r is the annual
 n 
interest rate, n is the number of compounding periods per year, and t is the time in years.
Example 3: Find the accumulated amount after 4 years if $1000 is invested at 6% per
year compounded (a) annually, (b) semiannually, (c) quarterly, (d) monthly, and (e) daily.
Continuous Compounding of Interest
A  Pe rt , where A is the accumulated amount, P is the principal, r is the annual interest

rate compounded continuously, and t is the time in years.
Example 4: Find the accumulated amount after 4 years if $1000 is invested at 6% per
year compounded (a) daily (assume a 365-day year) and (b) continuously.
Effective Rate of Interest

n
 r
ref  1    1 , where re is the effective rate of interest, r is the annual interest rate, and
 n 
n is the number of compounding periods per year.
Example 5: Find the effective rate of interest corresponding to a nominal rate of 6% per
year compounded (a) annually, (b) semiannually, (c) quarterly, (d) monthly, and (e) daily.
In 1968 Truth in Lending Act passed by Congress requires that the effective rate of
interest be disclosed in all contracts involving interest charges, giving consumers a
common basis for comparing the various rates quoted by different financial institutions.
Present Value
 nt
 r
P  A1   , where P is the present value, A is the future value, r is the annual
 n
interest rate, and n is the number of compounding periods per year.
Example 6: How much money should be deposited in a bank paying interest at the rate
of 6.2% per year compounded monthly so that at the end of 4 years the accumulated
amount will be $20,000?
Example 7: Find the present value of $48,000 due in 5 years at an interest rate of 8%
per year compounded quarterly.
Example 8: Blakely Investment Company owns an office building located in the

commercial district of a city. As a result of the continued success of an urban renewal
program, local business is enjoying a miniboom. The market value of Blakely’s property
is V (t )  300,000e t / 2 where V(t) is measured in dollars and t is the time in years from
the present. If the expected rate of inflation is 9% compounded continuously for the next
10 years, find an expression for the present value P(t) of the market price of the property
valid for the next 10 years. Compute P(7), P(8), and P(9) and interpret your results.
Example 9: Jane has narrowed her investment options down to two:
1. Purchase a CD that matures in 10 years and pays interest upon maturity at the
rate of 8% per year compounded daily (assume 365 days in a year).
2. Purchase a zero coupon CD that will triple her investment in the same period.
Which option will optimize her investments?
Example 10: Melissa has an Individual Retirement Account (IRA) with a brokerage firm.
Her money is invested in a money market mutual fund that pays interest on a daily basis.
Over a 2-year period in which no deposits or withdrawals were made, her account grew
from $4500 to $5268.24. Find the effective rate at which Moesha’s account was earning
interest over that period (assume 365 days in a year).

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Math 141 Lecture Notes: Section 5.1 Compound Interest

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Math 141 Lecture Notes

Section 5.1 Compound Interest

A  Pe rt , where A is the accumulated amount, P is the principal, r is the annual interest

Effective Rate of Interest

Example 8: Blakely Investment Company owns an office building located in the

Which option will optimize her investments?

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