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Mathematics in Banking - Compound Interest

By Expert Author: Chandra Jeet
Word Count: 535 words | Views: 624 view(s)
NO banking WITHOUT Mathematics.

Many of you would have learned about Simple interest and compound interest in your middle school. Simple interest is seldom used in practice. The concept of compound interest is used in banks and many financial institutions.

Let’s begin with the definition of “interest”.

Interest is a fee paid for a loan or an amount of money borrowed from a bank or other financial institution. Banks pay interest on money deposited by customers.

There are two types of interest, simple interest and compound interest.

Simple Interest

Simple interest is the interest paid only on the original principal. Simple interest is quite easy to calculate.

The simple interest formula is I = PRT

Where

I – simple interest
P – Principal or the initial amount of money that was invested or borrowed
R – Rate of interest as a decimal
T – Time

Compound Interest

Compound interest involves paying interest upon interest. That is, compound interest is the interest calculated on the accrued unpaid interest and on the original principal.
Compound Interest is a bit more complicated than Simple Interest.

The compound interest formula is:

A = P (1 + R) ^T, if the interest is compounded once a year

A = P [1 + (R/N)] ^NT, if the interest is compounded ‘N’ times a year

Where

A – Amount = Principal + interest
P – Principal or the initial amount of money that was invested or borrowed
R – Rate of interest as a decimal
T – Time

When you deposit money in the bank, always choose the account that offers you compound interest. You would make a little more money with the compound interest account than the simple interest account.
Albert Einstein, the great scientist once quoted: "Compound interest is the eighth wonder of the world. He, who understands it, earns it ... he who doesn't ... pays it”.

Let’s look at a couple of examples:

Mrs. Green deposited $5000 for 5 years at 4% simple interest. Calculate the amount of interest Mrs. Green will get back at the end of 5 years.

Let’s use the simple interest formula: I = PRT

Here: P = $5000, R = 4% = 0.04, T = 5 years

I = PRT = 5000 × 0.04 × 5 = 1000

So, Mrs. Green will receive $1000 at the end of 5 years.

Mrs. Green deposited $5000 for 5 years at 4% compounded quarterly. Calculate the amount of interest Mrs. Green will get back at the end of 5 years.

There are 4 quarters in a year. So, the interest is compounded 4 times a year.

Let’s use the compound interest formula: A = P[1 + (R/N)]^NT

Here: P = $5000, R = 4% = 0.04, N = 4, T = 5 years

A = P [1 + (R/N)] ^NT = 5000[1 + (0.04/4)] ^ (4×5) = 5000(1 + 0.01)^20 = 5000(1.01)^20 = 6100.95

So, Mrs. Green will receive $6100.95 – $5000 = $1100.95 at the end of 5 years.

Notice that Mrs. Green makes a little more money with compound interest.

Banks and other financial institutions use compound interest to calculate how much interest to be charged on a loan amount and how much interest to be paid on money deposited by customers.

The more frequent the compounding, the more money you can make.
The longer you allow your money to remain in the account, the greater is the final amount you receive.
Chandra Jeet

About the Author:

I’m Chandra Jeet, an in-house writer for iCoachMath. iCoachMath is an effective, convenient, easy-to-use online Math Program which has been used by thousands of students, teachers, and parents. iCoachMath strives to lead K-12 students to excellence in math by offering quality web-based educational solutions. iCoachMath’s instructional and lesson materials are aligned to State Curriculum Standards in all 50 states (USA).
iCoachMath

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