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EC07

1. Simple interest is charged only on the principal amount without considering accrued interest, while compound interest is calculated on the principal plus previously accumulated interest over time periods. 2. Nominal interest rate refers to the stated annual interest rate, while effective interest rate considers interest compounded more frequently than annually resulting in a true periodic rate. 3. Compounding interest more frequently than annually, such as quarterly, results in a higher effective annual interest rate than the nominal rate and greater total interest earned over the investment period.

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25 views22 pages

EC07

1. Simple interest is charged only on the principal amount without considering accrued interest, while compound interest is calculated on the principal plus previously accumulated interest over time periods. 2. Nominal interest rate refers to the stated annual interest rate, while effective interest rate considers interest compounded more frequently than annually resulting in a true periodic rate. 3. Compounding interest more frequently than annually, such as quarterly, results in a higher effective annual interest rate than the nominal rate and greater total interest earned over the investment period.

Uploaded by

engrsaab51
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ENGINEERING ECONOMICS

LECTURE - 07

Simple and Compound Interest

1
Definition
• Simple interest is interest that is charged on
sum P loaned or borrowed for a period of n
years at a uniform rate of i. for the n periods.
• Compound Interest: compound interest can
be thought of as interest on top of interest.
• Nominal Interest Rate: r.

• Effective Interest Rate: i.

2
Nominal and Effective Interest Rates

Many financial transactions require


that interest be compounded more
often than once a year (semi-
annually, quarterly, monthly, daily
etc). In such situations, there are two
expressions for the interest rate.
1.The nominal interest rate, r,
2.The effective interest rate, i, 3
Nominal Interest Rates

The nominal interest rate, r,


is expressed on an annual
basis: this is the rate that is
normally quoted when
describing an interest
bearing transaction.
4
Effective Interest Rates

The effective interest rate, i, is the


rate that corresponds to the
actual interest period. The
effective interest rate is obtained
by dividing the nominal interest
rate by m, the number of interest
periods per year.
i=r/m 5
Nominal Interest Rates
• The term “nominal” means “in
name only”
• In other words, it is not the real
interest rate!

• We need a way to convert a nominal


interest rate to the true effective
interest rate that will actually apply!
6
Nominal Interest Rates

r = (effective interest rate/period) (# of periods)

• So the effective interest rate can be computed as:

effective interest rate/period = r/(# of periods)

7
Effective Interest Rates
• An effective interest rate is a true,
periodic interest rate:
– That applies for a stated period of
time
• It is conventional to use a year as the
standard period of time:
– So, we would like to be able to
convert a nominal interest rate to
an effective annual interest rate
8
Examples
• 1.5% per month effective interest
rate:
– Is the same as (1.5%) (12) = 18%
nominal interest rate per year

• 1% per week effective interest rate:

– Is the same as (1%) (52) = 52% nominal


interest rate per year
9
Problem:

A bank claims to pay interest to its depositors at


the rate of 6% per year compounded quarterly.
What are the nominal and effective interest
rates?
Solution:
a) The nominal interest rate is r=6%

b) Since there are four interest periods


per year the effective interest rate
is

i=r/m
i = 6% / 4 = 1.5% per quarter 10
Comparison of
Nominal and Effective Interest Rates
It has become customary to
quote interest rates on an annual
basis, followed by a
compounding period if different
from one year in length

11
Comparison of
Nominal and Effective Interest Rates
Example: If the interest rate is 6% per interest
period and the interest period is six months,
it is customary to speak of this rate as “12%
compounded semiannually.”
Here the annual rate of interest is known as
the nominal rate, 12 % in this case. But the
actual annual rate on the principle is not 12%
but some thing greater, because
compounding occur twice during the year.
12
Consequently, the frequency
at which nominal interest rate
is compounded each year can
have a pronounced effect on
the dollar amount of total
interest earned

13
For instance, consider a principal
amount of $1000 to be invested for
three years at 12% compounded
semiannually
The interest earned during the first six
months would be $1000 * (0.12/2) =
$60.
Total principal and interest at the
beginning of the second six-month
period is P+Pi= $1000 + $60=$1060
14
The interest earned during the
second six months would be
$1060*(0.12/2) = $63.60
The total interest earned during the
year is
$60.00 + 63.60 = $123.60
Finally, the effective annual interest
rate for the entire year is
($123.60 / $1000) * 100 = 12.36%15
Simple Interest
• Simple Interest: It is interest that is computed
only on the original sum and not on accrued
interest (without regards to the yearly interest).
• Thus if your loan at present is P at a simple
annual interest rate i (stated as a decimal)for a
period of n years, the amount of interest you on
loan would be:
• Total interest earned = P x i x n = Pin
(At the end of n years the amount of money
F = P +interest, F = P + Pin , or F = PO + in.)
16
Compound Interest
• Compound Interest: It is a situation where the
interest at the beginning of each term is re-
assessed (unlike simple interest) for invested
or borrowed money and the interest of previous
period is added to the Principal of next period.
• Thus, in practice we assume that the rate of
interest (unless stated as simple) is a always
compound interest rate.

17
Example
• You have agreed to loan a friend $5000 for 5
years at a simple interest rate of 8% per year.
How much interest will you receive from the
loan'? How much will your friend pay you at the
end of 5 years?
• If it becomes compound interest. How will this
change affect the amount that your friend pays
you at the end of 5 years?
• Compare both

18
Solution
• P = $5000 n 5 years, i= 8% per year.
• Simple Interest
• P x i x n = 5000 x 5 x 8/100
• = $ 2000,
• Final / Terminal Total Value
• F= 5000 + 2000 = 7000

• Compound Interest: see next


19
Example- Compound Interest

20
Assignment
• What is the total return for a person who pays
PKR 1000 per month for 3 years to an
organization whose agreement with client was
12 % profit compounded monthly.

21
22

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