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Chapter 8

Chapter 8. Simple Interest. When is Simple Interest Used. Borrowing and lending money has become a widespread practice. Loans are issued at simple interest rate or simple discount rate and can be paid back either in a single payment or a series of payments.

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Chapter 8

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  1. Chapter 8 Simple Interest

  2. When is Simple Interest Used • Borrowing and lending money has become a widespread practice. • Loans are issued at simple interest rate or simple discount rate and can be paid back either in a single payment or a series of payments.

  3. Section 1: Basic Simple Interest • Interest: Rent (or Fee) paid for the privilege of borrowing money. • I = PRT, where • I = interest (in dollars) • P = principal • R = rate(interest rate) • T = time • Principal: The original amount of money that is loaned or borrowed; the investment value on which interest is computed.

  4. Basic Simple Interest • A certain percentage of the principal is charged as interest. • Rate = percent charged, usually quoted as an annual rate. • Time: is the number of days, months, or years for which the money will be loaned. • RATE and TIME must correspond, time is ALWAYS converted to years because the rate is given on a yearly basis.

  5. Simple Interest • I = PRT • The amount due on the ending date of the loan (Maturity Value) is the sum of the principal plus the interest. This expressed by the formula: • M = P + I

  6. Additional Terms • Date:The date on which a note is drawn. • Due Date: The date on which a note is to be repaid; the maturity date. • Face Value: the money value specified on a promissory note; the principal of a simple interest note. • Maker: the person who signs a note promising to repay a loan.

  7. Additional Terms • Maturity Value: The total amount principal plus interest due on a simple interest loan. • Payee:the person (or bank or firm) to whom the maturity value of a note will be paid.

  8. Section 2: Ordinary and Exact Time • Sometimes loans are made for a certain number of days. • If a loan is made on July 5 for 30 days, computing the interest depends on whether it is ordinary or exact time. • Ordinary time: the assumption that every month has 30 days, thus any 5-month period would be computed as 5 x 30 = 150 days. This method is seldom used. • Exact Time: the specific numbers of days within the time period is calculated. Thus, 90 days would usually be slightly less than 3 months. Exact time may be calculated most conveniently using the Number of Each Day of the Year table (in your packet).

  9. Exact Time • The Number of Days in a Year table: • Each day is assigned a number from 1 to 365.

  10. Section 3: Ordinary Interest and Exact Interest • Ordinary Interest: Calculates interest using 360 days per year Ordinary Interest: t = Exact Days / 360 The combination of exact days and 360-day year is known as the Bankers’ Rule, a name derived from the fact that banker (as well as other financial institutions) generally compute their interest in this way: Exact Days / 360 • Exact Interest:Calculates interest using 365 days per year Exact Interest: t = Exact Days / 365

  11. Section 4: Simple Interest Notes • Promissory Note: a written promise to repay a loan (either with or without interest, and with or without collateral) • Collateral: an item of value used to secure the loan. • Most notes are short term, 1 year or less, most common time period is 90 days.

  12. Banks and Promissory Notes • Short term loans are usually either installment loans or simple discount loans. • Installment loan, the maturity amount is paid monthly or even weekly. • Bank is required to provide the borrower the following information: Annual percentage rate and finance charge (the fee for using the banks money).

  13. Section 5: Present Value • Present Value: • (1) The Principal; also (2) the value of another investment that, if made (on any given date) at the rate money is worth, would have the same maturity value as the actual, given investment P = M / (1 + rt)

  14. Example: 1 Conclusions • Many investments involve two different interest rates. • Rate money is worth: The annual or typical rate currently being used at most financial institutions. • Banks charges a higher interest on their notes then you earn in your deposits…….why?

  15. Types of interest earning deposits: • Certificate of Deposit (CD) A savings investment that earns a higher interest rate than savings accounts because the money is committed for a set period of time (usually a 3 month minimum ); and may also require a minimum investment (often $1000) • Savings Account: a low interest account where any amount may be deposited or withdrawn at anytime; also called an open account. • Money-market account: combined savings/CD account that requires a minimum balance (often $500) but allows a limited number of checks or withdrawals. Pays higher interest than regular savings. But lower than CDs.

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