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13.

1 Compound Interest
Simple interest interest is paid only on the
principal
Compound interest interest is paid on both
principal and interest, compounded at regular
intervals
Example: a $1000 principal paying 10% simple
interest after 3 years pays .1 3 $1000 = $300
If interest is compounded annually, it pays .1
$1000 = $100 the first year, .1 $1100 = $110
the second year and .1 $1210 = $121 the third
year totaling $100 + $110 + $121 = $331 interest

13.1 Compound Interest


Period

Interest
Credited

Times
Credited
per year

Rate per
compounding
period

Annual
Semiannual

year
1
6 months 2

Quarterly

quarter

R
4

Monthly

month

12

R
12

R
R
2

13.1 Compound Interest


Compound interest formula:

M P (1 i )

and

I M P

M = the compound amount or future value


P = principal
i = interest rate per period of compounding
n = number of periods
I = interest earned

13.1 Compound Interest


Time Value of Money with interest of 5%
compounded annually.
2000
$1000 $1000

n
(1 i )
(1.05)10

2010

$1000

2020
$1000(1 i ) n
$1000(1.05)10

13.1 Compound Interest


Example: $800 is invested at 7% for 6 years. Find
the simple interest and the interest compounded
annually
Simple interest:
I PRT $800 .07 6 $336
Compound interest:

M P(1 i ) n $800(1.07)6 $1200.58


I M P $1200.58 $800 $400.58

13.1 Compound Interest


Example: $32000 is invested at 10% for 2
years. Find the interest compounded yearly,
semiannually, quarterly, and monthly
yearly:
M P(1 i ) n $32000(1.10) 2 $38720
I M P $38720 $32000 $6720
semiannually:
M P(1 i ) n $32000(1.05) 4 $38896.20
I M P $38896.20 $32000 $6896.20

13.1 Compound Interest


Example: (continued)
quarterly:
M P (1 i ) n $32000(1.025)8 $38988.89
I M P $38988.89 $32000 $6988.89

monthly:
i 1012% .833%, n 12 2 24
M P(1 i ) n $32000(1.00833) 24 $39052.20
I M P $39052.20 $32000 $7052.20

13.2 Daily and Continuous


Compounding
Daily compound interest formula: divide i by 365
and multiply n by 365

M P(1

i 365 n
365

and

I M P

Continuous compound interest formula:

M Pe

yr

y # years r rate per year

13.2 Daily and Continuous


Compounding
Time Value of Money with 5% interest
compounded continuously.
2000
$1000 $1000
10 (.05)
yr
e
e

2010

$1000

2020
$1000e yr
$1000e10 (.05)

13.2 Daily and Continuous


Compounding
Example: Find the compound amount if $2900 is
deposited at 5% interest for 10 years if interest is
compounded daily.

M P(1

i 365 n
365

$2900(1
$4781.13

5% 3650
365

13.2 Daily and Continuous


Compounding
Example: Find the compound amount if $1200 is
deposited at 8% interest for 11 years if interest is
compounded continuously.
11 0.08

M Pe $1200 e
$2893.08
I M P $2893.08 $1200
$1693.08
yr

13.2 Daily and Continuous


Compounding Early Withdrawal

Early Withdrawal Penalty:


1. If money is withdrawn within 3 months of the
deposit, no interest will be paid on the money.
2. If money is withdrawn after 3 months but
before the end of the term, then 3 months is
deducted from the time the account has been
open and regular passbook interest is paid on
the account.

13.2 Daily and Continuous


Compounding Early Withdrawal
Example: Bob Kashir deposited $6000 in a 4-year
certificate of deposit paying 5% compounded daily.
He withdrew the money 15 months later. The
passbook rate at his bank is 3 % compounded daily.
Find his amount of interest.

Bob receives 15-3 = 12 months of 3.5 % interest


compounded daily
i 365 n

M P (1 365 )

.5% 365
$6000(1 3365
)

$6210.73

13.3 Finding Time and Rate


Given a principal of $12,000 with a compound
amount of $17,631.94 and interest rate of 8%
compounded annually, what is the time period in
years?
M P (1 i ) n

$17,631.94 $12,000(1 8%) n


17631.94
1.469328 (1.08) n
12000
From Appendix D table pg 805( i = 8%) we find that
n = 5 years

13.3 Finding Time and Rate


Example:Find the time to double your investment
at 6%.
M P (1 i ) n

2 1(1 6%) n
2 (1.06) n
If you try different values of n on your calculator,
the value that comes closest to 2 is 12. Therefore
the investment doubles in about 12 years.

13.3 Finding Time and Rate


Example:Given an investment of $13200,
compound amount of $22680.06 invested for 8
years, what is the interest rate if interest
is
n
compounded annually? M P(1 i )
22680.06 13200(1 i )8
22680.06
1.71818 (1 i )8
13200
From Appendix D table pg 803( i = 7%) we find
that for n=8, column A = 1.71818 so i = 7%.

13.4 Present Value at Compound


Interest
Example:Given an amount needed (future
value) of $3300 in 4 years at an interest rate of
11% compounded annually, find the present
value and the amount of interest earned.
M P (1 i ) n
3300 P (1 11%) 4
3300
P
$2173.81
4
(1.11)
3300 2173.81 $1126 .19

13.4 Present Value at Compound


Interest
Example: Assume that money can be invested at
8% compounded quarterly. Which is larger, $2500
now or $3800 in 5 years?
First find the present value of $3800, then
compare present values:
M P (1 4i ) 4 n
3800 P (1

8% 4 5
4

P 1.02

20

3800
P
$2557.29 $3800 in 5 years
20
(1.02)

14.1 Amount (Future Value) of an Annuity


Annuity a sequence of equal payments
Payment period time between payments
Ordinary annuity payments at the end of the
pay period
Annuity due - payments at the beginning of the
pay period
Simple annuity payment dates match the
compounding period (all our annuities are simple)

14.1 Amount (Future Value) of an Annuity


Amount of an annuity - S (future value) of n
payments of R dollars for n periods at a rate of i
per period:

1 i n 1
S R
R sn i
i

Use you calculator instead of using appendix D.

14.1 Amount (Future Value) of an Annuity


Example: Sharon Stone deposits $2000 at the end
of each year in an account earning 10%
compounded annually. Determine how much
money she has after 25 years. How much interest
did she earn?
1 .10 25 1
9.834706
S 2000
2000
.10
.10

$196,694.12
I 196,694.12 (25 2000) $146,694.12

14.1 Amount (Future Value) of an Annuity


Example: For S = $50,000, i = 7% compounded
semi-annually with payments made at the end of
each semi-annual period for 8 years, find the
periodic payment (R)
1 72% 28 1

$50,000 R

7%
2

50,000 20.97103R
50000
R
$2384.24
20.97103

1.03516 1

0
.
035

14.1 Amount (Future Value) of an Annuity


Example: For S = $21,000, payments (R) of $1500
at the end of each 6-month period i = 10%
compounded semi-annually. Find the minimum
number of payments to accumulate 21,000.
1 102% n 1

$21,000 $1500

10%
2

21,000
1.05 1

14

1500
0
.
05

1.05 n 1

1500

0
.
05

Trying different values for n, the expression goes over 14


when n = 11 (Exact value = 4.20678716(1500)=$21310.18)

14.1 Amount of an Annuity Due


An annuity due is paid at the beginning of each
period instead of at the end. It is essentially the
same as an ordinary annuity that starts a period
early but without the last payment.
To solve such a problem:
1. Add 1 to the number of periods for the
computation.
2. After calculating the value for S, subtract the
last payment.

14.1 Amount of an Annuity Due


Example:Sharon Stone deposits $500 at the
beginning of each 3 months in an account earning
10% compounded quarterly. Determine how much
money she has after 25 years
n 25 4 1 101, i 10% 4 .025
1.025 101 1
11.1091
S 500
500
500 500
0.025
0.025

$221,681.19

14.2 Present Value of an Annuity


Present value of an annuity (A) made up of
payments of R dollars for n periods at a rate of i
per period:

1 i n 1
A R
R an i
n
i 1 i

14.2 Present Value of an Annuity


Example: What lump sum deposited today would
allow payments of $2000/year for 7 years at 5%
compounded annually?
5
i 5%
.05
100
1.05 7 1
A 2000
7
.051.05
.407100
2000
$11,572.71
.0703552

14.2 Present Value of an Annuity


Example: Kashundra Jones plans to make a lump sum
deposit so that she can withdraw $3,000 at the end of
each quarter for 10 years. Find the lump sum if the
money earns 10% per year compounded quarterly.
10%
i
.025, n 10 4 40
4
1.025 40 1
1.684064
A 3000

3000

40
.0671266
.0251.025
$75,263.64

14.3 Sinking Funds


Sinking fund a fund set up to receive periodic
payments.
The purpose of this fund is to raise an amount of
money at a future time.
Bond promise to pay an amount of money at a
future time.
(Sinking funds can be set up to cover the face
value of bonds.)

14.3 Sinking Funds


Amount of a sinking fund payment:

i
1
R S
S
n
sn i
1 i 1

Same formula as in section 14.1, except solved for


the variable R.

14.3 Sinking Funds


Example: 15 semiannual payments are made into a
sinking fund at 7% compounded semiannually so
that $4850 will be present. Find the amount of
each payment rounded to the nearest cent.
7% .07
i

.035
2
2

i
.035
R S
$4850
n
15
(
1
.
035
)
1

$251.35

14.3 Sinking Funds


Example: A retirement benefit of $12,000 is to be paid
every 6 months for 25 years at interest rate of 7%
compounded semi-annually. Find (a) the present value to
fund the end-of-period retirement benefit. ): (b) the end-ofperiod semi-annual payment needed to accumulate the
value in part (a) assuming regular investments for 30 years
in an account yielding 8% compounded semi-annually.
7% .07
i

.035, n 2 25 50
2
2
1.035 50 1
4.584927
A 12,000

12
,
000


50
0.195472
.0351.035
$281,468.06

14.3 Sinking Funds


Example(part b) amount to save every 6 months
for 30 years for this annuity
8% .08
i

.04, n 30 2 60
2
2
i
.04
RS
281,468.06
n
1 i 1
1.04 60 1
.04

281,468.06
$1182 .69
9.519627

15.1 Open-End Credit


Open-end credit the customer keeps making
payments until no outstanding balance is owed
(e.g. charge cards such as MasterCard and Visa)
Revolving charge account a minimum amount
must be paid account might never be paid off
Finance charges charges beyond the cash price,
also referred to as interest payment
Over-the-limit fee charged if you exceed your
credit limit

15.1 Open-End Credit


Example: Find the finance charge for an
average daily balance of $8431.10 with
monthly interest rate of 1.4%
finance charge 0.014 $8431.10
$118 .04

15.1 Open-End Credit


Example: Find the interest for the following
account with monthly interest rate of 1.5%
Previous balance $412.48
November 5
Billing date
November 18

Payment

$150

November 30

Dinner and play

$84.50

15.1 Open-End Credit


Example(continued)
Date
# days until chg balance (2)(3)
November 5 13
$412.48 5362.24
November 18 12
$262.48 3149.76
November 30 5
$346.98 1734.9
December 5
30 (total days)
10246.9
Average balance = 10246.930 = $341.56
Finance charge = .015 341.56 = $5.12
Balance at end = 346.98 + 5.12 = $352.10

15.2 Installment Loans


A loan is amortized if both principal and interest
are paid off by a sequence of periodic payments.
For a house this is referred to as mortgage
payments.
Lenders are required to report finance charge
(interest) and their annual percentage rate (APR)
APR is the true effective annual interest rate for a
loan

15.2 Installment Loans

In order to find the APR for a loan paid in


installments, the total installment cost, finance
charge, and the amount financed are needed
1.

Total installment cost = Down payment + (amount of


each payment number of payments)
2. Finance charge = total installment cost cash price
3. Amount financed = cash price down payment
Finance charge
4. Get:
$100
Amount financed

5.

Use table 15.2 to get the APR

15.2 Installment Loans

Example: Given the following data, find the


finance charge and the total installment cost
Amount Down
Cash # of
Amount of
Financed Payment Price payments payment
$650

$125

$775 24

$32

Total installment cost $125 24 $32 $893


Finance charge $893 $775 $118

15.2 Installment Loans

Example: Given the following data, find the


annual percentage rate using table 15.2
Amount Finance # of
Financed Charge payments
$345

$24.62

12

( 2)
$100
1
24.62
100 7.14
345

from table 15.2 # payments = 12, APR is


approximately 13%

15.3 Early Payoffs of Loans


United States rule for early payoff of loans:
1. Find the simple interest due from the date the
loan was made until the date the partial payment
is made.
2. Subtract this interest from the amount of the
payment.
3. Any difference is used to reduce the principal
4. Treat additional partial payments the same way,
finding interest on the unpaid balance

15.3 Early Payoffs of Loans

Example: Given the following note, find the balance due


on maturity and the total interest paid on the note.

1.

Principal

Interest

Time in days

Partial payments

$5800

10%

120

$2500 on day 60

Find the simple interest for 60 days and subtract it


from the payment.
I PRT $5800 0.10

60
$96.67
360

2.

Subtract it from the payment:

3.

Reduce the principal by the amount from (2)

$2500 96.67 $2403.33

$5800 $2403.33 $3396.67

15.3 Early Payoffs of Loans

Example(continued)
Interest due at maturity:

60
I PRT $3396.67 0.10
$56.61
360

Balance due on maturity (add reduced principal to interest):

Total interest paid on the note (add interest paid to interest due at
3396.67 56.61 $3453.28
maturity):

96.67 56.61 $153.28

15.3 Early Payoffs of Loans

Rule of 78 (sum-of-the-balances method)


Note (1+2+3++12) sum of the month numbers adds
up to 78 used to derive the formula.
U = unearned interest, F = finance charge, N = number
of payments remaining, and P = total number of
payments
N 1 N
U F

P 1 P

15.4 Personal Property Loans

From section 14.2, the present value of an


annuity (A) made up of payments of R dollars
for n periods at a rate of i per period:
1 i n 1
A R
n
i 1 i

i 1 i
so R A

n
1 i 1

15.4 Personal Property Loans

A loan is made for $3500 with an interest rate of


9% and payments made annually for 4 years.
What is the payment amount?
.09(1.09) 4
i 1 i
R A
$3500

n
4
(
1
.
09
)

$1080.34

15.4 Personal Property Loans

A loan is made for $4800 with an APR of 12%


and payments made monthly for 24 months.
What is the payment amount? What is the
finance charge?
12% .12
i

.01
12
12
.01(1.01) 24
R $4800
$229.95
24
(1.01) 1
f .c. 24 225.95 4800 $622.80

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