Lesson 15 of 35 · Quantitative Reasoning: word problems
Interest and growth: simple, compound and repeated change
Tell simple from compound interest, compute compound growth by hand, compare compounding periods and work growth and decay backwards.
About 20 minutes
In this lesson
- Compute simple and compound interest, and the difference between them.
- Handle compounding more than once a year.
- Model repeated growth or decay with a constant factor, and work it backwards to find a rate.
The idea
Simple interest grows by a fixed amount
Simple interest is paid only on the original amount, the principal:
where is the principal, the yearly rate as a decimal and the time in years. at 5% simple interest earns every year, so over three years. The balance grows in a straight line.
Compound interest grows by a fixed factor
Compound interest is paid on the balance, including interest already earned, so each year's interest is larger than the last. With yearly compounding,
and with compounding times a year at a yearly rate ,
Quarterly compounding at 8% a year means 2% per quarter, four times a year. The more often interest is compounded, the more the account ends up holding, though the gain from compounding more often is small.
Powers worth knowing by hand
Without a calculator, these products come up again and again:
| Factor | Square | Cube |
|---|---|---|
Square a factor like by expanding: . The expansion also shows why compounding helps: the extra is interest on interest.
Compound minus simple
Over two years at rate , compound interest exceeds simple interest by
the interest earned in the second year on the first year's interest. On at 6% that is . Questions that give this difference and ask for the principal or the rate are solved with this one line.
Growth and decay in general
Interest is one case of repeated percent change. Anything that grows by a fixed percent per period is multiplied by the same factor each period: a population growing 3% a year is multiplied by per year; a car losing 15% of its value a year is multiplied by . Quantities that double or triple in a fixed time work the same way: bacteria that triple every 20 minutes are multiplied by in two hours, since two hours contain six 20-minute periods. Count the periods carefully; that is where most errors start.
Working backwards
To find an earlier value, divide by the factor. To find a rate, divide the end value by the start value and recognise the power: growth from to over two years is a factor of , so the yearly rate is 10%.
Estimating
For a rough doubling time, the rule of 72 gives about years; at 8% a year, money doubles in roughly 9 years ( is just under 2). Use it only to discard answer choices that are far off, never for an exact answer.
Worked examples
Example 1: Simple against compound
is invested for two years at 6% a year. How much more interest does it earn with yearly compounding than with simple interest?
Simple interest: .
Compound: , so the balance is and the interest is .
Difference: . Check with .
Answer
more with compounding.
Example 2: Compounding twice a year
is deposited for one year at 10% a year, compounded every six months. What is the balance at the end of the year, and how does it compare with yearly compounding?
Twice a year at 10% a year means 5% per half-year, applied twice: .
, so the balance is .
Check step by step: after six months ; after a year . Yearly compounding gives .
Answer
, which is more than yearly compounding. Applying the full 10% twice would give , the slip of not dividing the rate by the number of periods.
Example 3: Finding the rate
An investment grew from to in two years with interest compounded yearly at a constant rate. What was the yearly rate?
The two-year growth factor is .
A two-year factor is the yearly factor squared, and , so the yearly factor is and the rate is 10%.
Check forwards: and .
Answer
10% a year. Dividing the total growth of 21% by two years gives 10.5%, which treats compound growth as simple interest.
Common traps
Treating compound interest as simple
Compound growth over several periods is a power, not a multiple: 10% a year for two years is a factor of , not . Dividing a total percent change by the number of years overstates the yearly rate.
Using the yearly rate for each period
With quarterly compounding the rate per quarter is a quarter of the yearly rate, and there are four times as many periods. Divide the rate and multiply the number of periods.
Miscounting periods
"Triples every 20 minutes for two hours" is six periods, not two or five. "In the third year" means the interest for one year, earned on the balance after two years, not three years of interest.
Subtracting a decay three times from the start
A 10% yearly fall over three years is , a 27.1% fall, not 30%. Each fall is taken of the reduced value.
Check yourself
Answer each question before you open its answer.
Question 1: Interest in the third year
Problem Solving
is invested at 5% a year, compounded yearly. How much interest is earned during the third year alone?
- A.$210.00
- B.$220.50
- C.$600.00
- D.$630.50
- E.$4,630.50
Show the answer
Answer: B. $220.50
Working
After two years the balance is . The third year's interest is 5% of that: . Check: after three years , and .
Why the other options are wrong
- A. $210 is the interest for the second year, earned on $4,200.
- C. $600 is three years of simple interest, not one year of compound interest.
- D. $630.50 is the total interest over all three years.
- E. $4,630.50 is the balance after three years.
What carries over
Interest in one year is the rate times the balance at the start of that year.
Question 2: Quarterly against yearly
Problem Solving
is deposited for one year at 8% a year. How much more will the account hold at the end of the year if interest is compounded quarterly rather than yearly?
- A.$0
- B.$16.00
- C.$24.32
- D.$800.00
- E.$824.32
Show the answer
Answer: C. $24.32
Working
Quarterly: 2% per quarter for four quarters. and , so the balance is . Yearly: . Difference: . Check by expansion: ; everything beyond is , and .
Why the other options are wrong
- A. This assumes how often interest is added makes no difference; quarterly compounding earns interest on interest.
- B. $16 is the gain from compounding twice a year (), not four times.
- D. $800 is the interest with yearly compounding, not the difference between the two methods.
- E. $824.32 is the total interest with quarterly compounding, not the extra over yearly compounding.
What carries over
More frequent compounding adds a little interest on interest; divide the rate and multiply the periods.
Question 3: A shrinking population
Problem Solving
A town of 12,000 people loses 10% of its population each year. What will its population be after 3 years?
- A.8,400
- B.8,748
- C.9,720
- D.10,800
- E.15,972
Show the answer
Answer: B. 8,748
Working
Multiply by each year: . Year by year: , then , then .
Why the other options are wrong
- A. This takes 10% of the original 12,000 three times, a fall of 30%; each fall is taken of the reduced population.
- C. 9,720 is the population after 2 years, one period short.
- D. 10,800 is the population after 1 year.
- E. This applies 10% growth, , instead of a 10% decline.
What carries over
Repeated percent change is a power of one factor; count the periods.
Key points
Simple interest adds ; compound interest multiplies by each period.
With compoundings a year, use rate for periods.
Over two years, compound minus simple interest is .
Any repeated percent change is a power of one factor; divide by it to go backwards.
All questions here are original and written for UniExamer; none comes from the test maker.
Written by the UniExamer team with AI assistance. Every worked example and check question was re-solved by an independent checker before publication. No subject expert has reviewed this lesson yet. If you find a mistake, write to support@uniexamer.com.