Basic Concepts 1.1INTEREST Interest is a fee that is charged for the use of someone else's money.

The size of the fee will depend upon the total amount of money borrowed and the length of time over which it is borrowed. Example 1.1 An engineer wishes to borrow $20 000 in order to start his own business. A bank will lend himthe money provided he agrees to repay $920 per month for two years. How much interest is he being charged?The total amount of money that will be paid to the bank is 24x$920= $22 080. Since the original loan isonly $20 000, the amount of interest is $22 080-$20 000=$2080. Whenever money is borrowed or invested, one party acts as the lender and another party as theborrower. The lender is the owner of the money, and the borrower pays interest to the lender for theuse of the lender's money. For example, when money is deposited in a savings account, the depositoris the lender and the bank is the borrower. The bank therefore pays interest for the use of thedepositor's money. (The bank will then assume the role of the lender, by loaning this money toanother borrower, at a higher interest rate.) 1.2INTEREST RATE If a given amount of money is borrowed for a specified period of time (typically, one year), a certain percentage of the money is charged as interest. This percentage is called the interest rate. Example 1.2 (a) A student deposits $1000 in a savings account that pays interest at the rate of 6%per year.How much money will the student have after one year? (b)An investor makes a loan of $5000, to be repaid inone lump sum at the end of one year. What annual interest rate corresponds to a lump-sum payment of $5425? (a) The student will have his original $1000, plus an interest payment of 0.06X $1000 =$60. Thus, the studentwill have accumulated a total of $1060 after one year. (Notice that the interest rate is expressed as adecimal when carrying out the calculation.) (b) The total amount of interest paid is $5425-$5000= $425. Hence the annual interest rate is Interest rates are usually influenced by the prevailing economic conditions, as well as the degree of risk associated with each particular loan. 1.3 SIMPLE INTEREST Simple interest is defined as a fixed percentage of the principal (the amount of money borrowed),multiplied by the life of the loan. Thus, I=nip where I=total amount of simple interest n=life of the loan

i=interest rate (expressed as a decimal) P=principal It is understood that n and irefer to the same unit of time (e.g., the year). Normally, when a simple interest loan is made, nothing is repaid until the end of the loan period;then, both the principal and the accumulated interest are repaid. The total amount due can beexpressed as F=P+I=P(l+ni) Example 1.3 A student borrows $3000 from his uncle in order to finish school. His uncle agrees to charge himsimple interest at the rate of 5% per year. Suppose the student waits two years and then repays the entire loan.How much will he have to repay? By (1.2), F=$3000[1+ (2)(0.055)]=$3330. 1.4 COMPOUND INTEREST When interest is compounded, the total time period is subdivided into several interest periods (e.g., one year, three months, one month). Interest is credited at the end of each interest period, and is allowed to accumulate from one interest period to the next. During a given interest period, the current interest is determined as a percentage of the total amount owed (i.e., the principal plus the previously accumulated interest). Thus, for the first interest period, the interest is determined a sand the total amount accumulated is For the second interest period, the interest is determined as I=iP and the total amount accumulated is F1=P+I1=P+Ip=P(1+i) For the second interest period, the interest is determined as I2=iF1=i(1+i)P and the total amount accumulated is F2=P+I1+I2=P+iP+i(1+i)P=P(1+i)^2 For the third interest period, I3=i(1+i)^2 F3=P(1+ i)^3

and so on. In general, if there are n interest periods, we have (dropping the subscript): F=P(l+i)" (1-3) which is the so called law of compound interest. Notice that F, the total amount of moneyaccumulated, increases exponentially with n, the time measured in interest periods. Example

1.4 A student deposits $1000 in a savings account that pays interest at the rate of 6% per year,compounded annually. If all of the money is allowed to accumulate, how much will the student have after 12years? Compare this with the amount that would have accumulated if simple interest had been paid. BY (1.31, F = $1000(1+ 0.06)" = $2012.20Thus, the student's original investment will have more than doubled over the 12 year period.If simple interest had been paid, the total amount that would have accumulated is determined by (1.2) as F = $1000[1+ (12)(0.06)] = $1720.00 1.5 THE TIME VALUE OF MONEY Since money has the ability to earn interest, its value increases with time. For instance, $100today is equivalent to F = $100(1+ 0.07)5 = $140.26