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2
Interest
Objectives
1. Understand the simple interest formula.
2. Use the compound interest formula to nd future value.
3. Solve the compound interest formula for different unknowns, such as the present
value, length, and interest rate of a loan.
The most powerful force in the universe is. . . .
How would you nish this quote? The world-renowned physicist Albert Einstein said,
. . . compound interest.
Are you surprised that of all the forces that he might pick, Einstein chose this one? In this
section, we will explain how interest can either work for youor against you. As you will
see, used properly, it can help you build a fortune; used improperly, it can lead you to
nancial ruin.
If you want to accumulate enough money to buy a newer car or go on a vacation, you
could deposit money in a bank account. The bank will use your money to make loans to
other customers and pay you interest for using your funds. However, if you borrow money
from the bank, say to take a college course, then you will pay interest to the bank. In
essence, interest is the money that one person (a borrower) pays to another (a lender) to
use the lenders money. Savers earn interest; borrowers pay interest.
We will discuss simple and compound interest in this section, and discuss the cost of
consumer loans in Section 9.3.
Simple Interest*
The amount you deposit in a bank account is called the principal. The bank species an
interest rate for that account as a percentage of your deposit. The rate is usually expressed
as an annual rate. For example, a bank may offer an account that has an annual interest rate
of 5%. To nd the interest that you will earn in such an account, you also need to know
how long the deposit will remain in the account. The time is usually stated in years. There
is a simple formula that relates principal, interest earned, interest rate, and time. In words,
interest earned = principal * interest rate * time.
When we compute interest this way, it is called simple interest.
F ORMUL A F OR COMPUTI NG S I MPL E I NTERES T We calculate simple inter-
est using the formula
I = Prt,
where I is the interest earned, P is the principal, r is the interest rate, and t is the time in
years.
KEY POINT
Simple interest is a
straightforward way to
compute interest.
*If you want some practice with basic algebra, see Appendix A.
Copyright 2010 Pearson Education, Inc.
9.2 y Interest 405
EXAMPLE 1 Calculating Simple Interest
If you deposit $500 in a bank account paying 6% annual interest, how much interest
will the deposit earn in 4 years if the bank computes the interest using simple interest?
SOLUTI ON: In this example:
P is the principal, which is $500
r is the annual interest rate, which is 6% (written as 0.06)
t is the time, which is 4 (years)
Thus, the interest earned is
I = Prt = 500 * 0.06 * 4 = 120.
In 4 years, this account earns $120 in interest.
Now try Exercises 5 to 8. ]
To nd the amount that will be in your account at some time in the future, called the
future value (or sometimes called the future amount) we add the principal and the inter-
est earned. We will represent future value by A, so we can say
A = principal + interest = P + I.
If we replace I by Prt, we get the formula A = P + Prt = P(1 + rt).
COMPUTI NG F UTURE VAL UE US I NG S I MPL E I NTE RE S T To nd the
future value of an account that pays simple interest, use the formula
A = P(1 + rt ),
where A is the future value, P is the principal, r is the annual interest rate, and t is the
time in years.
EXAMPLE 2 Computing Future Value Using Simple Interest
Assume that you deposit $1,000 in a bank account paying 3% annual interest and leave the
money there for 6 years. Use the simple interest formula to compute the future value of this
account.
SOLUTI ON: We see that P = 1,000, r = 0.03, and t = 6. Therefore,
Thus, your bank account will have $1,180 at the end of 6 years. ]
In contrast to future value, the principal that you have to invest in an account now to
have a specified amount in the account in the future is called the present value of the
account. Notice that the formula for computing future value has four unknowns. If we
want, we can use this formula for finding the present value of an account provided
we know the future value, interest rate, and time.
EXAMPLE 3 Finding the Present Value of an Account
Assume that you plan to save $2,500 to take a white-water rafting trip in Costa Rica in
2 years. Your bank offers a certicate of deposit (CD) that pays 4% annual interest com-
puted using simple interest. How much must you put in this CD now to have the necessary
money in 2 years?
P r
A 1,000(1 (0.03)(6)) 1,000(1 0.18) 1,000(1.18) 1,180.
t
KEY POINT
Future value equals principal
plus interest.
Copyright 2010 Pearson Education, Inc.
Quiz Yourself
Continue Example 4 to calculate
the amount in your account at the
end of the fourth year.
6
KEY POINT
Compounding pays interest
on previously earned
interest.
Quiz Yourself
Redo Example 3, but now
assume that you want to save
$2,400 in 4 years and the
CD has an annual interest rate
of 5%.
5
CHAPTER 9 y Consumer Mathematics 406
Year
Principal (Beginning of Year)
P
Future Value (End of Year)
P(1 + rt) = P(1.10)
1 $2,000
$2,000(1.10) = $2,200
2 $2,200
$2,200(1.10) = $2,420
3 $2,420
$2,420(1.10) = $2,662
*When calculating a deposit to accumulate a future amount, we will always round up to the next cent.
An interest rate of 10% would be extraordinarily high. However, we will often choose rates in examples and
exercises to keep the computations simple.
SOLUTI ON: We can use the formula
A = P(1 + rt).
We know that A = 2,500, r = 4% = 0.04, and t = 2. Therefore,
2,500 = P(1 + (0.04)(2)).
We can rewrite this equation as
2,500 = P(1.08).
Dividing both sides of the equation by 1.08, we get
We will round this up to $2,314.82 to guarantee that if you put this amount in the
CD now, in 2 years you will have the $2,500 you need for your white-water rafting trip.*
Now try Exercises 9 to 14. ]
Some Good Advice
In Example 3, we used the earlier formula for computing future value to nd the present value
rather than stating a new formula to solve this specic problem. You will nd it easier to learn
a few formulas well and use them, together with simple algebra, to solve new problems rather
than trying to memorize separate formulas for every type of problem.
Compound Interest
It seems fair that if money in a bank account has earned interest, the bank should compute
the interest due, add it to the principal, and then pay interest on this new, larger amount. This
is in fact the way most bank accounts work. Interest that is paid on principal plus previously
earned interest is called compound interest. If the interest is added yearly, we say that
the interest is compounded annually. If the interest is added every three months, we say the
interest is compounded quarterly. Interest also can be compounded monthly and daily.
EXAMPLE 4 Calculating Compound Interest the Long Way
Assume that you want to replace your sailboat with a larger one in 3 years. To save for a
down payment for this purchase, you deposit $2,000 for 3 years in a bank account that pays
10% annual interest,
1 3,500
1
6
3,500(1.01)
6
3,715.33.
r
m
0.12
12
n
number of months monthly interest rate
r
m
A = P a1 +
r
m
b
n
.
12%
4
=
0.12
4
= 0.03 = 3%
12%
12
=
0.12
12
= 0.01 = 1%
HI GHL I GHT
Between the NumbersIt Doesnt Hurt to Ask
In Example 5, you might ask yourself if you would be
better off borrowing the $3,500 from another source that has
a lower interest rate and paying for the tness center
outright.
If you have the money, sometimes a dealer might give
you a better price if you offer to pay for an item with cash.
The trick, of course, is to be able to put money aside so that
when you want to make a deal, you are not at the mercy of
someone elses money.
Copyright 2010 Pearson Education, Inc.
Example 6 illustrates a different way to use the compound interest formula.
EXAMPLE 6 Finding the Present Value for a College
Tuition Account
Upon the birth of a child, a parent wants to make a deposit into a tax-free account to use
later for the childs college education. Assume that the account has an annual interest rate
of 4.8% and that the compounding is done quarterly. How much must the parent deposit
now so that the child will have $60,000 at age 18?
SOLUTI ON: We will use the compound interest formula . Because we
know A = 60,000, r = 0.048, n = 72, and m= 4, we can nd the present value by solving the
equation
for P. Therefore,
A deposit slightly over $25,400 now will guarantee $60,000 for college in 18 years.
Now try Exercises 33 and 34. ]
Although $60,000 may seem like a lot of money, realize that ination, the increase in
the price of goods and services, will also cause the cost of a college education to increase.
We will consider the effects of ination in the exercises.
So far we have used the formula to nd A and P. Sometimes we want to nd
r or n. To do this, we need to introduce some new techniques.
If you want to solve for n in the formula , you need to be able to solve an
equation of the form a
x
= b, where a and b are xed numbers. A property of logarithmic
functions enables you to solve such equations. Many calculators have a key labeled either
log or log x, which stands for the common logarithmic function. Pressing this key
A = PA 1 +
r
m
B
n
A = PA 1 +
r
m
B
n
P =
60,000
(1.012)
72
=
60,000
2.360461386
L 25,418.76.
60,000 = Pa1 +
0.048
4
b
72
= P11 + 0.0122
72
A = PA 1 +
r
m
B
n
9.2 y Interest 409
HI GHL I GHT
Doing Financial Calculations with a Calculator*
When doing nancial computations, often technology can
speed up your work. We will use a calculator to reproduce
the solution to Example 6.
On my calculator, if we press the keys,
Screen 1 comes up. The letters TVM stand for Time Value of
Money. Then by choosing option 1, we get Screen 2. Now we
can enter the values 18 for N, the number of years; 4.8 for I%,
Finance 2nd
the annual interest rate; 60,000 for FV, the future value; and 4
for C/Y, the number of compounding periods per year. Next
we position the cursor over PV (present value) and press the
keys . The amount -25418.75939 for
present value means that we must deposit $25,418.76 now
to have the desired $60,000 in 18 years (Screen 3).
Solve Alpha
*For this example, I am using a TI-83 calculator, but many other calculators have similar features for doing nancial
calculations. On the TI-83 plus and TI-84, press the key and then choose option 1 to get screen 1. APPS
KEY POINT
We use the log function to
solve for n in the formula
A = PA 1 +
r
m
B
n
.
Screen 1 Screen 2 Screen 3
Copyright 2010 Pearson Education, Inc.
Quiz Yourself
Solve 6
x
= 15.
9
CHAPTER 9 y Consumer Mathematics 410
reverses the operation of raising 10 to a power. For example, suppose that you compute
10
5
= 100,000 on your calculator. If you next press the log key, the display will show 5. If
you enter 1,000, which is 10 raised to the third power, and press the log key, the display
will show 3. Practice nding the log of powers of 10 such as 100 and 1,000,000. If you
enter 23 and then press the log key, the display will show 1.361727836. The interpretation
of this result is that 10
1.361727836
= 23.* The log function has an important property that
will help us solve equations of the form a
x
= b.
E XPONE NT PROPE RTY OF THE L OG F UNCTI ON
log y
x
= x log y
To understand this property, you should use your calculator to verify the following:
log 4
5
= 5 log 4
log 6
3
= 3 log 6
Example 7 illustrates how to use the exponent property to solve equations.
EXAMPLE 7 Solving an Equation Using the Exponent
Property of the Log Function
Solve 3
x
= 20.
SOLUTI ON: We illustrate the steps required to solve this equation.
Now try Exercises 35 to 42. ]
In Example 8, we use the exponent property of the log function to nd the time it takes
an investment to grow to a certain amount.
EXAMPLE 8 Saving for Equipment for a Business
Mara wants to buy lighting equipment from her cousin to start a dance studio. He will sell
his equipment for $2,800. She presently has $2,500 and found an investment that will pay
her 9% annual interest, compounded monthly. In how many months will Mara be able to
pay her cousin for the equipment?
SOLUTION: We know that the future value that Mara must pay her cousin is A = 2,800. She
presently has $2,500 and the monthly interest rate is . We must solve
r
m
=
0.09
12
= 0.0075
9
*We will not discuss what it means to raise 10 to a power such as 1.361727836.
Step 1 Take the log of both sides of the equation. log 3
x
= log 20
Step 2 Use the exponent property of the log function. x log 3 = log 20
Step 3 Divide both sides by log 3.
x =
log 20
log 3
Step 4 Use a calculator to evaluate the right side of
the equation (your calculator may give a
slightly different answer).
x = 2.726833028
the compound interest formula for n, which represents the number of A = PA 1 +
r
m
B
n
months of the compounding. Substituting for A, P, and , we get the equation
2,800 = 2,500a1 +
0.09
12
b
n
.
r
m
Copyright 2010 Pearson Education, Inc.
Quiz Yourself
Do Example 8 again, but now
assume that the interest rate
is 6%.
10
9.2 y Interest 411
We solve this equation by the following steps:
1.12 = (1.0075)
n
Divide both sides of the
equation by 2,500 and simplify.
log(1.12) = log(1.0075)
n
Take the log of both sides.
log(1.12) = n log(1.0075) Use the exponent property of
the log function.
Solving for n, we get the equation
This means that Mara will have the money she needs by the end of the 16th month. ]
The last situation that we will consider is how to solve the compound interest equation
for r. To do this, we have to be able to solve an equation of the form x
a
= b,
where a and b are xed numbers. We show how to solve such an equation in Example 9.
EXAMPLE 9 Negotiating a Basketball Contract
Kobe is negotiating a new basketball contract with the Lakers and expects to retire after
playing one more year. In order to reduce his current taxes, his agent has agreed to
defer a bonus of $1.4 million to be paid as $1.68 million in 2 years. If the Lakers invest the
$1.4 million now, what rate of investment would they need to have $1.68 million to pay
Kobe in 2 years? Assume that you want to nd an annual interest rate that is compounded
monthly.
SOLUTI ON: To solve this compound interest problem, we again use the formula
. We know that A = 1.68, P = 1.4, m = 12, and n = 24.
Substituting for A, P, m, and n, we get the equation
Dividing both sides of the equation by 1.4 gives us . We can get rid of 1.2 = A 1 +
r
12
B
24
1.68 = 1.4a1 +
r
12
b
24
.
A = PA 1 +
r
m
B
n
A = PA 1 +
r
m
B
n
10
n =
log (1.12)
log (1.0075)
L 15.17.
the exponent 24 if we raise both sides of the equation to the power. This gives us the equation
*
Subtracting 1 from both sides of the equation, we get
Now, multiplying this equation by 12, we find the annual interest rate, r, to be
12(0.00762566) 0.0915. Thus, the Lakers need to find an investment that pays an
annual interest rate of about 9.15% compounded monthly.
Now try Exercises 43 to 46. ]
Some Good Advice
Be careful to distinguish between the situations in Examples 8 and 9. In Example 8, we used
the log function to solve an equation of the form a
x
= b. In Example 9, we solved an equation
of the form x
a
= b by raising both sides of the equation to the power.
1
a
L
r
12
= (1.2)
1/24
- 1 = 1.00762566 - 1 = 0.00762566.
(1.2)
1/24
= a a1 +
r
12
b
24
b
1/24
= 1 +
r
12
.
1
24
*In algebra, (a
x
)
y
= a
xy
. That is why . A A 1 +
r
12
B
24
B
1/24
= A 1 +
r
12
B
(24)(1/24)
= A 1 +
r
12
B
1
= 1 +
r
12
Copyright 2010 Pearson Education, Inc.
CHAPTER 9 y Consumer Mathematics 412
Exercises
9.2
Looking Back*
These exercises follow the general outline of the topics presented in
this section and will give you a good overview of the material that
you have just studied.
1. How did we nd the present value in Example 3?
2. Why did we divide the yearly interest rate of 0.12 by 12 in
Example 5?
3. What property of the log function did we use to solve the
equation 3
x
= 20 in Example 7?
4. What was our recommendation in the Between the Numbers
Highlight following Example 5?
Sharpening Your Skills
In Exercises 58, use the simple interest formula I = Prt and
elementary algebra to nd the missing quantities in the table below.
In Exercises 914, use the future value formula A = P(1 + rt) and
elementary algebra to nd the missing quantities in the table below.
22. $8,000, 4%, quarterly; 3 years
23. $20,000, 8%, monthly; 2 years
24. $10,000, 6%, monthly; 5 years
25. $4,000, 10%, daily; 2 years
26. $6,000, 4%, daily; 3 years
Savings institutions often state two rates in their advertising. One is
the nominal yield, which you can think of as an annual simple interest
rate. The other is called the effective annual yield, which is the actual
interest rate that the account earns due to the compounding. If $1,000
is in an account that pays a nominal yield of 9% and if the compound-
ing is done monthly, then after 1 year, the account would contain
$1,093.80, which corresponds to a simple interest rate of 9.38%. We
would say that this account has an effective annual yield of 9.38%. In
Exercises 2730, nd the effective annual yield for each account.
27. nominal yield, 7.5%; compounded monthly
28. nominal yield, 10%; compounded twice a year
29. nominal yield, 6%; compounded quarterly
30. nominal yield, 8%; compounded daily
In Exercises 31 and 32, you are given an annual interest rate and
the compounding period for two investments. Decide which is the
better investment.
31. 5% compounded yearly; 4.95% compounded quarterly
32. 4.75% compounded monthly; 4.70% compounded daily
In Exercises 33 and 34, Ann and Tom want to establish a fund for
their grandsons college education. What lump sum must they
deposit in each account in order to have $30,000 in the fund at the
end of 15 years?
33. Saving for college. 6% annual interest rate, compounded
quarterly
34. Saving for college. 7.5% annual interest rate, compounded
monthly
In Exercises 3542, solve each equation.
35. 3
x
= 10 36. 2
x
= 12
37. (1.05)
x
= 2 38. (1.15)
x
= 3
39. x
3
= 10 40. x
2
= 10
41. x
4
= 10 42. x
4
= 25
In Exercises 4346, use the compound interest formula A = P(1 + r)
t
and the given information to solve for either t or r. (We are assuming
that n = 1.)
43. A = $2,500, P = $2,000, t = 5
44. A = $400, P = $20, t = 35
45. A = $1,500, P = $1,000, r = 4%
46. A = $2,500, P = $1,000, r = 6%
I P r t
5. $1,000 8% 3 years
6. $196 7% 2 years
7. $700 $3,500 4 years
8. $1,920 $8,000 6%
In Exercises 1518, you are given an annual interest rate and the
compounding period. Find the interest rate per compounding period.
15. 18%; monthly 16. 8%; quarterly
17. 12%; daily