5.2: Simple Interest
Money is not free to borrow! We will refer to money in terms of present value P, which is an amount of money at the present time, and future value F, which is an amount of money in the future. Usually, if someone loans money to another person in present value, and are promised to be paid back in future value, then the person who loaned the money would like the future value to be more than the present value. That is because the value of money declines over time due to inflation. Therefore, when a person loans money, they will charge interest. They hope that the interest will be enough to beat inflation and make the future value more than the present value.
Simple interest is interest that is only calculated on the initial amount of the loan. This means you are paying the same amount of interest every year. An example of simple interest is when someone purchases a U.S. Treasury Bond.
Interest that is only paid on the principal.
\[F = P(1+rt) \nonumber \]
where,
- \(F\) is the Future value
- \(P\) is the Present value
- \(r\) is the Annual percentage rate (APR) changed to a decimal
- \(t\) is the Number of years
Sue borrows $2000 at 5% annual simple interest from her bank. How much does she owe after five years?
Solution
| Year | Interest Earned | Total Balance Owed |
|---|---|---|
| 1 | $2000*.05 = $100 | $2000 + $100 = $2100 |
| 2 | $2000*.05 = $100 | $2100 + $100 = $2200 |
| 3 | $2000*.05 = $100 | $2200 + $100 = $2300 |
| 4 | $2000*.05 = $100 | $2300 + $100 = $2400 |
| 5 | $2000*.05 = $100 | $2400 + $100 = $2500 |
After 5 years, Sue owes $2500.
Chad got a student loan for $10,000 at 8% annual simple interest. How much does he owe after one year? How much interest will he pay for that one year?
Solution
P = $10,000, r = 0.08, t = 1
\[F = P(1+rt) \nonumber \]
\[F = 10000(1+0.08(1)) = $10,800 \nonumber \]
Chad owes $10,800 after one year. He will pay $10800 - $10000 = $800 in interest.
Ben wants to buy a used car. He has $3000 but wants $3500 to spend. He invests his $3000 into an account earning 6% annual simple interest. How long will he need to leave his money in the account to accumulate the $3500 he wants?
Solution
F = $3500, P = $3000, r = 0.06
\[F = P(1+rt) \nonumber \]
\[\begin{align*} 3500 &= 3000(1+0.06t) \\ \dfrac{3500}{3000} &= 1 + 0.06t \\ \dfrac{3500}{3000} - 1 &= 0.06t \\ \dfrac{\dfrac{3500}{3000}-1}{0.06} &= t \end{align*} \nonumber \]
\[t\approx 2.8 \text{ years}\nonumber \]
Ben would need to invest his $3000 for about 2.8 years until he would have $3500 to spend on a used car.
Note: As shown above, wait to round your answer until the very last step so you get the most accurate answer.