Strategies, Sample Questions, and Random Ramblings.
July 19, 2015
This is another one of the topics that you will likely see more of in your first year of business school than on the GMAT, but getting down a few pieces of terminology and understanding how they are used will make your stress level come down if you see one on the exam and during your first year finance class.
Principle: The amount of an investment
Simple Interest: Interest that is paid on the principle alone
You do not have to memorize the formula above, but know that the interest amount will not change from year to year, this is a linear equation.
Compound Interest: Interest that is paid on principle and previously earned interest.
Interest here will increase each period because the principle grows over time. Remember to divide your interest by the number of compounding periods. Thus, 10% interest that is compounding semi-annually earns 5% for the first 6 months and 5% for the second 6 months. This type of interest is non-linear.
Even though we have just described the formulas, we are going to go through an example without using them so that you get an inherent understanding of exactly how this works.
If John earns 10% annual simple interest on $100, how much will he have after 2 years?
Year 1 Interest: 100(0.10) = 10
Year 2 Interest: 100(0.10) = 10
Thus, at the end of 2 years, John will have $120.
This is basically a percent problem disguised as an interest rate problem. Interest is only earned on the principle.
If John earns 20% annual interest on $100 how much will have have after 1 year if the interest compounds semi-annually?
Interest at 6 months: 100(0.10) = 10
Interest at 12 months: 110(0.10) = 11
Thus, at the end of the year, John will have $121.
This problem can be used with the formula, but again you just need to understand the basic concepts when doing GMAT interest problems.
Greg R., client, New York City
Emil C., client, Singapore
Chris S, client, New York City