Simple and Compound

Present Value and Future Value
Money has a present value and a future value. Unless

you are lending money to a friend, if you invest $P
today (the present value) for a promise of getting $F
at some future date (the future value), you expect F
to be more than P. Otherwise, why do it? The same
principle also works in reverse. If you are getting a
present value of P today from someone else (either in
cash or in goods), you expect to have to pay a future
value of F back at some time in the future. If we are
given the present value P, how do we find the future
value F (and vice versa)?
Copyright © 2010 Pearson Education, Inc. Excursions in Modern Mathematics, 7e: 10.2 - 1
Interest Rate
The answer depends on several variables, the most
important of which is the interest rate. Interest is
the return the lender or investor expects as a
reward for the use of his or her money, and the
standard way to describe an interest rate is as a
yearly rate commonly called the annual
percentage rate (APR).
Thus, we can say, “I am investing my money in an
account that pays an APR of 5%,” or “I have to pay a
24% APR on the balance on my credit card.”
Simple Interest or Compound Interest
The APR is the most important variable in
computing the return on an investment or the
cost of a loan, but several other questions come
into play and must be considered. Is the interest simple
or compounded? If compounded, how often is it compounded? Are there
additional fees? If so, are they in addition to the interest or are they
included in the APR? We will consider these questions in Sections 10.2 and
10.3.
Simple Interest
In simple interest, only the original money invested

or borrowed (called the principal) generates
interest over time. This is in contrast to compound
interest, where the principal generates interest,
then the principal plus the interest generate more
interest, and so on.
Example 10.7 Savings Bonds
Imagine that on the day you were born your parents
purchased a $1000 savings bond that pays 5% annual
simple interest. What is the value of the bond on your
18th birthday? What is the value of the bond on any
given birthday? Here the principal is P = $1000 and the
annual percentage rate is 5%. This means that the
interest the bond earns in one year is 5% of $1000, or
(0.05)$1000 = $50. Because the bond pays simple
interest, the interest earned by the bond is the same
every year.
Example 10.7 Savings Bonds
Thus,
■ Value of the bond on your 1st birthday
= $1000 + $50 = $1050.
■ Value of the bond on your 2nd birthday
= $1000 + (2  $50) = $1100
…
■ Value of the bond on your 18th birthday
= $1000 + (18  $50) = $1900 .
■ Value of the bond when you become
t years old = $1000 + (t  $50).
SIMPLE INTEREST FORMULA
The future value F of P dollars invested

under simple interest for t years at an
APR of R% is given by
F = P(1 + r • t)
(where r denotes the R% APR written as

a decimal).
Simple Interest
You should think of the simple interest formula as a
formula relating four variables: P (the present value), F
(the future value), t (the length of the investment in
years), and r (the APR). Given any three of these
variables you can find the fourth one using the
formula. The next example illustrates how to use the
simple interest formula to find a present value P given
F, t, and r.
Example 10.8 Government Bonds:
Part 2
Government bonds are often sold based on their future
value. Suppose that you want to buy a five-year $1000
U.S.Treasury bond paying 4.28% annual simple interest
(so that in five years you can cash in the bond for $1000).
Here $1000 is the future value of the bond, and the price
you pay for this bond is its present value.
Example 10.8 Government Bonds:
Part 2
To find the present value of the bond, we let
F = $1000, R = 4.28%, and t = 5 and use the simple
interest formula. This gives
$1000 = P[1 + 5(0.0428)] = P(1.214)
Solving the above equation for P gives
$1000
P  $823.72
1.214
(rounded to the nearest penny).
Credit Cards
Generally speaking, credit cards charge exceptionally

high interest rates, but you only have to pay interest if
you don’t pay your monthly balance in full. Thus, a
credit card is a two-edged sword: if you make
minimum payments or carry a balance from one
month to the next, you will be paying a lot of interest;
if you pay your balance in full, you pay no interest.
Credit Cards
In the latter case you got a free, short-term loan from

the credit card company. When used wisely, a credit
card gives you a rare opportunity–you get to use
someone else’s money for free. When used unwisely
and carelessly, a credit card is a financial trap.
Example 10.9 Credit Card
Use: The Good, the Bad
and
Imagine that you the got
recently Ugly
a new credit card. Like
most people, you did not pay much attention to the
terms of use or to the APR, which with this card is a
whopping 24%. To make matters worse, you went out
and spent a little more than you should have the first
month, and when your first statement comes in you are
surprised to find out that your new balance is $876.
and cards,
Like with most credit the Ugly
you have a little time from
the time you got the statement to the payment due date
(this grace period is usually around 20 days). You can pay
a minimum payment of $20, the full balance of $876, or
any other amount in between. Let’s consider these three
different scenarios separately.
and
■ Option 1: Pay thebalance
the full Uglyof $876 before the
payment due date. This one is easy. You owe no
interest and you got free use of the credit card
company’s money for a short period of time. When
your next monthly bill comes, the only charges will be
for your new purchases.
and
■ Option 2: Pay the Ugly
the minimum payment of $20. When
your next monthly bill comes, you have a new balance
of $1165 consisting of:
1. The previous balance of $856. (The $876 you

previously owed minus your payment of $20.)
2. The charges and thenew
for your Ugly
purchases. Let’s say, for the
sake of argument, that you were a little more careful
with your card and your new purchases for this
period were $288.
and the
3. The finance charge Ugly
of $21 calculated as follows:
(i) Periodic rate = 0.02
(ii) Balance subject to finance charge
= $1050
(iii) Finance charge = (0.02)$1050 = $21
You might wonder, together with millions of other
credit card users, where these numbers come from.
Let’s take them one at a time.
(i) The periodicand
rate isthe Uglyby dividing the annual
obtained
percentage rate (APR) by the number of billing
periods. Almost all credit cards use monthly billing
periods, so the periodic rate on a credit card is the
APR divided by 12. Your credit card has an APR of
24%, thus yielding a periodic rate of 2% = 0.02.
(ii) The balanceand theto Ugly
subject finance charge (an official
credit card term) is obtained by taking the average
of the daily balances over the previous billing
period. Since this balance includes your new
purchases, all of a sudden you are paying interest
on all your purchases and lost your grace period! In
your case, the balance subject to finance charge
came to $1050.
(iii) The financeand the
charge Ugly by multiplying the
is obtained
periodic rate times the balance subject to finance
charge. In this case, (0.02)$1050 = $21.
■ Option 3: You make a payment that is more than

the minimum payment but less than the full
payment.
Let’s say for theand the
sake of Ugly that you make a
argument
payment of $400. When your next monthly bill comes,
you have a new balance of $777.64. As in option 2, this
new balance consists of:
1. The previous balance, in this case $476

(the $876 you previously owed minus the
$400 payment you made)
2. The new purchases of $288
3. The finance and the
charges, Ugly once again by
obtained
multiplying the periodic rate (2% = 0.02) times the
balance subject to finance charges, which in this case
came out to $682.
Thus, your finance charges turn out to be

(0.02)$682 = $13.64, less than under option
2 but still a pretty hefty finance charge.
Two Important Lessons
1. Make sure you understand the terms of your credit
card agreement.
Know the APR (which can range widely from less
than 10% to 24% or even more), know the length of
your grace period, and try to understand as much
of the fine print as you can.
Two Important Lessons
2. Make a real effort to pay your credit card balance in
full each month.
This practice will help you avoid finance charges
and keep you from getting yourself into a financial
hole. If you can’t make your credit card payments
in full each month, you are living beyond your
means and you may consider putting your credit
card away until your balance is paid.

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Present Value and Future Value

Money has a present value and a future value. Unless

In simple interest, only the original money invested

The future value F of P dollars invested

(where r denotes the R% APR written as

Generally speaking, credit cards charge exceptionally

In the latter case you got a free, short-term loan from

1. The previous balance of $856. (The $876 you

■ Option 3: You make a payment that is more than

1. The previous balance, in this case $476

Thus, your finance charges turn out to be

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