In this learning activity, you will learn to identify the difference between simple and compound interest. You will be able to solve problems that involve calculating simple and compound interest.

Pre-assessment review:

Check your prior knowledge of the following terms and conversion techniques related to finance that you will encounter in this learning activity.

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How would you define the term ‘invest’ in relation to finance?

What does the term ‘interest’ mean in relation to finance?

What does the term ‘loan’ mean in relation to finance?

How do you convert a percentage into a decimal?

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Let's explore the following videos which explain how to distinguish debts that have simple interest and debts with compound interest.

Summer savings with simple interest

A person sits at a desk displaying a piggy bank wih carefully stacked coins next to it.

Mara and Aram are a young couple who want to invest for their future. Concept of simple and compound interest has been explained by using their situations as examples. Aram worked during the summer vacation doing minor landscaping and cutting lawns. Instead of spending the paycheques, they decided to deposit the $1,000 in a bank account that earns 4% interest each year for six years.

At the end of each year, Aram received a cheque for the interest earned. Find out how much interest Aram earned in the following activity.

What is simple interest?

The interest that is either earned (or paid) on the original sum of money invested (or borrowed) is simple interest.

The sum of money that is borrowed or invested is called principal.

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Explore the following video to find out more about simple interest.

What is the formula for simple interest?

The interest earned depends on three factors:

  • Principal, P (the money invested).
  • Rate, r (the annual interest rate).
  • Time, t (the time for which the money is invested).

This is the formula for calculating simple interest:

Formula for simple interest: I=Prt

  • I is the interest earned in dollars.
  • P is the principal invested in dollars.
  • r is the annual interest rate, in decimal form.
  • t is the time in years.

Take note of the following equation, as you’ll need it to calculate the total amount of an investment over time.

When money is invested, the sum of the principal and the interest is called the amount of an investment.

  • Amount is Principal + Interest
  • Formula: A=P+I

A=P+I

To find out Aram’s interest each year for six years: first, we must convert 4% to a decimal, 0.04(4%=4/100=0.04). This is called the rate of interest. We then have to multiply the rate with $1,000 to find the interest earned at the end of each year.

The following table shows the amount of interest Aram will earn each year.

Year Amount in account ($) Suggested Solutions
1 1,000
2 1,000
3 1,000
4 1,000
5 1,000
6 1,000

Notice that the amount of interest stays the same each year and so, it represents simple interest because the interest is not reinvested.

Only the original amount of $1,000, called the principal, earns interest each year. The interest earned is paid separately at the end of each year.

To determine the accumulated interest, add the interest earned at the end of each year. The last column in the following table shows the accumulated interest.

Year Amount in account ($) Interest received ($) Suggested Solutions
1 1000 1,000×0.04=40
2 1000 1,000×0.04=40
3 1000 1,000×0.04=40
4 1000 1,000×0.04=40
5 1000 1,000×0.04=40
6 1000 1,000×0.04=40

Notebook

Notebook

In your notebook, determine the pattern for the accumulated interest in each year and compare with the suggested solution.

Using the year number and accumulated interest values from the following table produce a graph of simple interest earned over time.

Year Simple interest ($)
1 40
2 80
3 120
4 160
5 200
6 240

Investing $2,000 prize using simple interest

An older person in a very classy suit gives an excited younger person a novelty blank cheque.

Aram is a talented individual. To earn more money, Aram submitted a short story to a creative writing contest and won the top prize: a cheque for $2,000.

A term deposit is a fixed-term investment that locks your principal away until the term is over. Consider a situation in which Aram invested the $2,000 in an 18-month term deposit account that paid 3.5% per year. As noted earlier:

I=Prt

To find how much interest (I) Aram earned, you need to identify the following elements:

  • principal(p)
  • rate(r)
  • time(t)

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The principal is the initial amount invested. How much is Aram’s principal?

What is the interest rate? Convert this to a decimal.

What is the time? (This is time in years, so you may have to determine the fraction of a year.)

Now you can use I=Prt to find the interest. What is the interest?

In some problems you may have to solve for P, r, or t.

Borrowing from a bank

Stylish depiction of a plant growing out of coins spilling from a jar.

Consider a situation in which Aram paid $165 in interest for borrowing a sum of money at an interest rate of 2.75% annually for four years. Based on these values, calculate how much money Aram borrowed initially.

To calculate how much Aram borrowed you will have to first find the interest rate, the time, and the interest.

What was Aram's rate?

What was Aram’s time?

What was Aram’s interest?

Use the formula I=Prt to find the principal.

The death of Mara’s great-aunt

Depiction of a last will and testament featuring a gavel, two sacks of money and legal documents with old timey lettering.

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Mara tells Aram that an inheritance is due from a great-aunt. Consider a situation in which Mara invests the inheritance of $5,000.

Mara decides to buy a seven-year, $5,000 Guaranteed Investment Certificate (GIC) that earns 5.8% per year.

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Determine the interest that Mara earned on the GIC.

What is the amount of the GIC at the end of seven years?

Summer savings with compound interest

Someone crawls through the grass desperately trying to grab a series of increasingly large piggy banks ahead of him.

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Earlier we learned that Aram deposited $1,000 in an account that pays 4% simple interest for six years. Let’s consider the interest received if interest had been reinvested back in Aram's account.

Each year, Aram receives $40, hence, at the end of six years total received interest is $240.

Suppose Aram reinvested the interest back into the account. Explore how this situation is different from simple interest. The table below represents the calculations for the amounts earned each year if Aram had invested in a 4% compound interest account.

lo

Year

Principal for year (P)

Interest earned (I)

Accumulated interest ($)

1

1,000

1,000×0.04=40

40

2

1,000+40=1,040

1,040×0.04=41.60

40+41.60=81.60

3

1,040+41.60=1,081.60

1,081.60×0.04=43.26

81.60+43.26=124.86

4

1,081.60+43.26=1,124.86

1,124.86×0.04=45.00

124.86+45.00=169.86

5

1,124.86+45.00=1,169.86

1,169.86×0.04=46.79

169.86+46.79=216.65

6

1,169.86+46.79=1,216.65

1,216.65×0.04=48.67

216.65+48.67=265.32

When Aram invested $1,000 in a simple interest account, and earned a total of $240 in interest over 6 years. In this new situation, by reinvesting the interest earned at the end of each year into the account, Aram now earns $265.32 in interest over 6 years.

The interest difference between the two investments is $265.32–$240=$25.32. Therefore, Aram earns $25.32 more in interest by adding it to the principal each year.

When interest is earned on interest, that interest compounds. This describes another type of interest—, compound interest.

In other words, interest calculated at regular periods and added to the principal for the next period is called compound interest.

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Explore the following video to deepen your understanding of compound interest.

Compare simple interest and compound interest by investigating the amount of interest Aram earned on his $1,000 in each situation. Examine the following two tables. Table A indicates the change in simple interest each year. Table B indicates the change in compound interest each year.

Table A: $1,000 invested at 4% simple interest.

Year

Total interest

Change in interest

1

$40

----------

2

$80

$40

3

$120

$40

4

$160

$40

5

$200

$40

6

$240

$40

Table B:$1,000 invested at 4% compound interest.

Year

Total interest

Change in interest

1

$40

----------

2

$81.60

$41.60

3

$124.86

$43.26

4

$169.86

$45.00

5

$216.65

$46.79

6

$265.32

$48.67

For simple interest, the interest increases by the same amount each year.

For compound interest, the interest increases by a greater amount each year. It is compounded annually. This means the yearly interest is added to the principal amount and reinvested, therefore gaining even more interest.

In each table, the third column, change in interest, represents the finite differences (specifically, the first differences). You may want to review finite differences.

You already know that simple interest represents linear growth, so it makes sense that the finite differences are constant.

In Table B, the values in the third column are not constant, which indicates that compound interest is not linear. You can confirm this by graphing Simple interest vs. Compound interest.

Notebook

Notebook

Sketch the following graph in your notebook, use the values in columns 1 and 2 of Tables A and B.

The graph confirms that compound interest does not represent linear growth.

Determine the ratio of finite difference to determine the type of function it represents (divide the change in interest for a given year by the change in interest from the year before) For example, the ratio of finite differences between year 2 and year 1 is $43.26/$41.60=1.04.

Year Total interest Change in interest Ratio Suggested solutions
1 $40 $41.60
2 $81.60 $43.26
3 $124.86 $45.00
4 $169.86 $46.79
5 $216.65 $48.67
6 $265.32

Since the ratio of the change in compound interest is constant, then compound interest represents exponential growth.

Mara purchases a Guaranteed Investment Certificate (GIC)

Series of stacks of money increasing in size with a squiggly arrow indicating financial growth over time.

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Money grows more rapidly when interest is compounded because it grows exponentially. Here’s an exercise involving compound interest.

Mara purchases a $1,500 GIC that earns 6.25% interest each year for eight years.

Determine the total interest earned at the end of each year using simple interest. Organize your calculations using the provided table.

Year Principal (P) Simple interest (I) Accumulated simple interest ($)
1 1,500 1,500×0.0625=93.75 93.75
2 1,500 1,500×0.0625=93.75 187.50
3
4
5
6
7
8

Next, determine the total interest earned at the end of each year using compound interest. Organize your calculations using the following table.

Year Principal for year ($) Compound interest ($) Accumulated compound interest ($)
1 1,500 1,500×0.0625=93.75 93.75
2 1,500+93.75=1,593.75 1,593.75×0.0625=99.61 93.75+99.61=193.36
3
4
5
6
7
8

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Determine the amount of the investment under simple interest.

Determine the amount of the investment under compound interest.

How much extra interest is earned under compound interest?

Solving compound interest problems

Here is a handy formula for solving compound interest problems when you want to know the total amount. With this formula, you do not need to add the interest earned to the principal because the formula does that step for you, automatically.

The formula of an investment when the interest is compounded is:

A=P(1+i)nwhere:

  • A is the amount.
  • P is the principal.
  • i is the compounded interest rate as a decimal.
  • n is the number of compounding periods. For interest compounded annually, this is the number of years.

In the following examples, you will use the annual compounded interest formula and the Time Value Money (TVM) Solver.

Borrowing money to buy a laptop

A young professional sits at a laptop during the day.

To buy a new laptop for a home business, Mara borrows $1,600 at an interest rate of 3.5% per annum compounded annually. Mara plans to pay back the loan in three years.

Method 1: Using the formula

A=P(1+i)n

  • How much will Mara owe in 3 years?
  • How much interest will Mara owe after three years?

How much interest will Mara pay for the loan?

Method 2: Using TVM solver

This type of problem can also be solved with a financial calculator. This method is particularly helpful when solving more difficult problems such as a payment deal in which the lender is misleading you about the actual interest rate. In your case, you’ll get to use the TVM solver.

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The TVM solver can help you calculate the various parameters related to compound interest. It’s based on the future value of TVM equation:

FV=PV×(1+I)N×periods per year

This is similar to the equation for compound interest.

A=P(1+i)n

This is not by accident!

Let’s examine each component of the TVM equation to find out how they relate to what you already know about the compound interest equation.

Now, let’s take the TVM solver out for a test drive! The following is the same problem you saw previously. To buy a new laptop for a home business, Mara borrows $1,600 at an interest rate of 3.5% per annum compounded annually. The plan is to pay back the loan in three years.

  • How much will Mara owe after three years?
  • How much interest will Mara pay for the loan?

Can you solve the following problems on your own using the TVM solver? Give it a shot and examine.

Start (Opens in a new window)

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How much will Mara owe after three years?

How much interest will Mara pay for the loan?

Mara dreams of university

Someone in a graduation outfit is putting coins in a piggy bank.

In some problems, you want to know how much you should invest today to have a certain amount of money in the future.

In the following situation, Mara wants to know how much to invest today to cover tuition fees for her first year of university.

To find the principal or present value of an investment, you can rewrite the formula A=P(1+i)n so P is isolated. Try to rearrange the formula for P, if you can.

In five years, Mara will need $8,000 to cover tuition fees for first year of university. How much money should Mara invest today, at a rate of 7.25% compounded annually, so that there is enough money to pay tuition fees?

Different compounding periods

For some investments or loans, the interest is compounded more than once a year. For instance, if you have money invested in a daily interest account, then the interest earned is compounded daily, or 365 times a year. The following table is a summary of possible compounding periods.

Frequency of compounding

Number of times interest is added during a year

Annually

1 (every year)

Semi-annually

2 (every six months)

Quarterly

4 (every three months)

Monthly

12 (every month)

Daily

365 (every day)

For these questions, the formula A=P(1+i)n can still be used to determine amounts when the interest is compounded more than once a year; however, the interest rate must be divided by the number of compounding periods in order to find the amount of interest per compounding period.

Three different compounding periods for Aram’s investment

Aram now considers the option of three different compounding periods for his $1,000 investment at 4% interest over 6 years: semi-annually, quarterly and monthly.

Someone crawls through the grass desperately trying to grab a series of increasingly large piggy banks ahead of him.

Press here for long description(Open in new window)

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Try determining the final amount when compounded monthly and compare your answer with the suggested solution.

What is the amount after six years, compounded monthly?

Which compounding period should Aram select? Justify your choice.

Aram uses a TVM solver to dream big!

Use the TVM Solver to answer each of the following questions.

Start (Opens in a new window)

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Aram is investing $5,000 in an account that earns 6.95% compounded monthly for seven years. What is the amount in the account at the end of this time?

Aram plans for a big anniversary

Aram attends a major sporting arena and wins the 50/50 charity drawing happening that night. As a result, $10,000 goes to helping children with special needs sporting groups and $10,000 is the prize that was awarded to Aram, who really wants a motorcycle.

Two young people taking a selfie by a cliff near their motorcycle.

Aram now has $10,000 to invest for five years. At the end of five years, Aram would like to have $16,000 to buy a new motorcycle. What rate of interest, to the nearest hundredth of a percent, compounded quarterly, does Aram need to achieve the goal?

Simple and compound interest practice problems

  1. International Express (a non-existent credit card company) charges an annual interest rate of 18% on unpaid account balances. Calculate the amount of interest that the company would charge when a balance of $2,200 is paid 43 days late.
Graphic depiction of a past due bill notification.
  1. Aram borrowed $1,350 for eight months to buy a new car and paid $38.25 in interest on the loan. What was the annual interest rate of Aram’s loan?

  1. In your notebook, describe the difference between simple and compound interest. What type of growth does each represent? Explain.
  1. Aram purchases a $2,500 Canadian Savings Bond that earns 7.5% interest each year for five years.

If you would like to learn about Canadian Saving Bonds, use your favourite internet search engine and enter the terms “Canada Savings Bonds” and “interest earned”. 2021 is a unique year to be learning about these bonds!

Determine the total interest earned at the end of each year under simple interest. Organize your calculations using the following table.

Year

Principal ($)

Simple interest ($)

Accumulated simple interest ($)

1

2

3

4

5

Determine the total interest earned at the end of each year under compound interest. Organize your calculations using the following table.

Year

Principal for Year ($)

Compound Interest ($)

Accumulated Compound Interest ($)

1

2

3

4

5

How much extra interest is earned under compound interest?

Determine the amount of the investment under simple interest.

Determine the amount of the investment under compound interest.

  1. Determine the change in interest for simple interest and compound interest. Organize your calculations using the following tables.

Table A – Simple interest: $2,500 invested at 7.5%

Year

Total interest

Change in interest

1

2

3

4

5

-

Table B – Compound interest: $2,500 invested at 7.5%

Year

Total interest

Change in interest

1

2

3

4

5

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Determine the ratio of the change in compound interest.

Describe the type of growth represented by each table. Justify your answer.

Using a pencil and paper, plot Year against Total interest for simple and compound interest on the same grid.

Aram invested $6,800 at 5.2% compounded semi-annually.

Determine the amount of the investment after four years.

What was the amount of the investment after seven years?

How much interest was earned on the investment between the fourth and the seventh year? Explain.

How much money should Mara invest now at a rate of 6.3% compounded monthly, to have $10,000 in five years?

Aram has $5,000 to invest in a GIC that earns 6% per year, compounded daily. How long will it take for Aram’s investment to double? Verify your answer using the TVM Solver.

Connections

Aram compares saving now vs. saving later

Explore the following video to better understand savings over time.

If you start at age 20, deposit $1,000 per year at 6% compounded annually, you will have $226,508 at age 65. If you start at age 50, deposit $1,000 per year at 6% compounded annually, you will have $25,672.55 at age 65.

Obviously, the first option is more profitable, so the sooner you can start saving, the better.

Rate your understanding on a scale of five to one.

Five means “I have a thorough understanding.” One means “I am confused.”

Are you able to:

Agree or Disagree statements ranked 1 to 5
Statement 1 2 3 4 5
I understand what simple and compound interest is.
I can calculate interest.

Reflection questions:

Now that you’ve completed this activity relating to simple and compound interest, contemplate the following questions to help you extend your understanding and consider how this knowledge and set of skills may relate to and impact your own life and the lives of others.

  • Why is it important to you to learn about some of the financial applications of mathematical functions?
  • How might you apply what you’ve learned in this activity to impact your own: education, home-life, work-life and community?
  • Consider some ways that you could use information and skills from this activity to help improve the lives of others both locally and globally.
  • Reflect on how an understanding of simple and complex interest could help you achieve potential future career goals.

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