Professional Documents
Culture Documents
Interest Rates
Chapter 3
Understanding Money Management
Debt Management
Focus
1. If payments occur more frequently than
annual, how do you calculate economic
equivalence?
2. If interest period is other than annual,
how do you calculate economic
equivalence?
3. How are commercial loans structured?
4. How should you manage your debt?
Nominal Versus Effective Interest Rates
= 1.5%
Effective Annual Interest Rate (Yield)
ia (1 r / M ) 1 M
: 1.5%
18% compounded monthly
or
1.5% per month for 12 months
=
Interest period
Payment period
Interest period
Payment period
Interest period
Effective Interest Rate per Payment Period
(i)( Discrete Compounding)
If cash flow transactions occur quarterly, but interest is
compounded monthly, we may wish to calculate the effective
interest rate on a quarterly basis. To consider this situation, we
may redefine as:
i [1 r / CK ] 1 C
One-year
K= 4
C=3
M=12 C
I = [1 + r/CK] -1
Case 0: 8% compounded quarterly
Payment Period = Quarter
Interest Period = Quarterly
1st Q
i [1 r / CK ]C 1
[1 0.08 / (13)( 4)]13 1
2.0186% per quarter
Effective Interest Rate per Payment Period with
Continuous Compounding
i [1 r / CK ] 1 C
(e )
r 1/ K
1
Case 3: 8% compounded continuously
Payment Period = Quarter
Interest Period = Continuously
1st Q
i er / K 1
e 0.02 1
2.0201% per quarter
Summary: Effective interest rate per quarter
8% 8% 8% 8%
compounded compounded compounded compounded
quarterly monthly weekly continuously
Payments Payments Payments Payments
occur quarterly occur quarterly occur quarterly occur quarterly
Given:
Invoice Price = $21,599
Sales tax at 4% = $21,599 (0.04) = $863.96
Dealers freight = $21,599 (0.01) = $215.99
Total purchase price = $22,678.95
Down payment = $2,678.95
Dealers interest rate = 8.5% APR
Length of financing = 48 months
Find: the monthly payment
Solution: Payment Period = Interest Period
$20,000
1 2 3 4 48
0
A
Given: P = $20,000, r = 8.5% per year
K = 12 payments per year
Find A
tep 1: M = 12
S
Step 2: i = r/M = 8.5%/12 = 0.7083% per month
Step 3: N = (12)(4) = 48 months
Step 4: A = $20,000(A/P, 0.7083%,48) = $492.97
Calculating an Effective Interest Rate Based on a Payment
Period
3.12 Find the effective interest rate per payment period for an interest rate of 8%
compounded monthly for each of the given payment schedule:
(a) Monthly
(b) Quarterly
(c) Semiannually
(d) Annually
3.13 What is the effective interest rate per quarter if the interest rate is 10%
compounded monthly?
3.14 What is the effective interest rate per month if the interest rate is 9%
compounded continuously?
3.15 What is the effective interest rate per quarter if the interest rate is 8%
compounded continuously?
3.16 James Hogan is purchasing a $30,000 automobile, which is to be paid for in 48
monthly installments of $650. What is the effective interest rate per month for
this financing arrangement?
3.17 Find the APY in each of the following cases:
(a) 10% compounded annually.
(b) 9% compounded semiannually.
(c) 12% compounded quarterly.
(d) 7% compounded daily.
Practice Problems
3.19 What is the future worth of each of the given series of payments?
(a) $12,000 at the end of each six-month period for 12 years at 8% compounded
semiannually.
(b) $8,000 at the end of each quarter for 6 years at 12% compounded quarterly.
(c) $6,000 at the end of each month for 5 years at 6% compounded monthly.
3.20 What equal series of payments must be paid into a sinking fund in order to
accumulate each given amount?
(a) $1,700 in 10 years at 8% compounded semiannually when payments are
semiannual.
(b) $9,000 in 6 years at 3% compounded quarterly when payments arc quarterly.
(c) $4,000 in 2 years at 12% compounded monthly when payments are monthly.
3.21 What is the present worth of each of the given series of payments?
(a) $2.700 at the end of each six-month period for 10 years at 8% compounded
semiannually.
(b) $10,000 at the end of each quarter for five years at 12% compounded quarterly.
(c) $14.000 at the end of each month for eight years at 6% compounded monthly.
3.25 Suppose a newlywed couple is planning lo buy a home two years from now. To save
the down payment required al the time of purchasing a home worth $400,000 (let's
assume this required down payment is 25% of the sales price, or $100,000), the couple
has decided to set aside some money from their salaries at the end of each month. If the
couple can earn 9% interest (compounded monthly) on their savings. determine the equal
amount the couple must deposit each month so that they may buy the home at the end of
two years.
3.33 Sam Musso is planning to retire in 20 years. He can deposit money at 12%
compounded quarterly. What deposit must he make at the end of each quarter until he
retires so that he can make a withdrawal of $55,000 semiannually over five years after
his retirement? Assume that his first withdrawal occurs at the end of six months after
his retirement.
3.38 Maria Anguiano's current salary is $80,000 per year, and she is planning to retire 25
years from now. She anticipates that her annual salary will increase by 3% each year.
(That is, in the first year she will earn $82,400, in the second year $84,872, in the third
year $87,418.16, and so forth.) She plans to deposit 6% of her yearly salary into a
retirement fund that earns 8% interest compounded monthly. What will be the amount
accumulated at the time of her retirement?
3.45 What is the required quarterly payment to repay a loan of $30,000 in six
years? If the interest rate is 9% compounded continuously?
3.46 A series of equal quarterly payments of $2,500 extends over a period of
four years. What is the present worth of this quarterly-payment series at 8%
interest compounded continuously?
3.47 A series of equal quarterly payments of $5,000 for 10 years is equivalent
to what future lump-sum amount at the end of 15 years at an interest rate of
6% compounded continuously?
3.56 Taibi Hafid is considering the purchase of a used car. The price, including the
title and taxes, is $10,500. Taibi is able to make a $2,500 down payment. The
balance, $8,000, will be borrowed from his credit union at an interest rate of 10%
compounded daily. The loan should be paid in 48 equal monthly payments.
Compute the monthly payment. What is the total amount of interest Taibi has to pay
over the life of the loan?
3.57 Janie Curtis borrowed $25,000 from a bank at an interest rate of 12%
compounded monthly. This loan is to be repaid in 48 equal monthly installments
over four years. Immediately after her 20th payment, Janie desires to pay the
remainder of the loan in a single payment. Compute the total amounts she must
pay at that time.
3.54 You borrow $200,000 with a 25-year payback term and a variable APR that
starts at 8% and can be changed every five years. (a) What is the initial monthly
payment? (b) If, at the end of five years, the lender's interest rate changes to 9%
(APR), what will the new monthly payment be?
3.59 For a $425,000 home mortgage loan with a 20-year term at 8% APR
compounded monthly, compute the total payments on principal and interest over
the first five years of ownership.
3.60 A lender requires that monthly mortgage payments be no more than one
third of gross monthly income, with a maximum term of 20 years. If you can
make only a 20% down payment, what is the minimum monthly income you
would need in order to purchase a $420,000 house when the interest rate is 12%
compounded monthly?
3.61 To buy an $180,000 condominium, you put down $30,000 and take out a
mortgage for $150,000 at an APR of 9% compounded monthly. Five years later,
you sell the house for $205,000 (after all selling expenses are factored in). What
equity (the amount that you can keep before any taxes are taken out) would you
realize with a 30-year mortgage repayment term? (Assume that the loan is
paid off when the condo is sold in lump sum.)
Practice Problem
5%
i 0.0137% per day
365
N 30 365 10, 950 days
F $2( F / A, 0.0137%,10950)
$50, 831
Case II: When Payment Periods Differ from Compounding
Periods M K
Step 1: Identify the following parameters
M = No. of compounding periods
K = No. of payment periods
C = No. of interest periods per payment period
Step 2: Compute the effective interest rate per payment
period
For discrete compounding
i [1 r / CK ] 1
C
ie0 .12 / 4
1
3.045% per quarter
Step 3: N = 4(3) = 12
Step 4: F = $1,000 (F/A, 3.045%, 12)
= $14,228.37
Practice Problem
A = $5,000
1 2 40 Quarters
(a) Quarterly
Payment period :
A = $5,000
Quarterly
Interest Period:
0
Quarterly
1 2 40 Quarters
9%
i 2.25% per quarter
4
N 40 quarters
P $5, 000( P / A, 2.25%, 40)
$130,968
(b) Monthly
Payment period :
A = $5,000
Quarterly
Interest Period: Monthly
0
1 2 40 Quarters
9%
i 0.75% per month
12
i p (1 0.0075)3 2.267% per quarter
N 40 quarters
P $5, 000( P / A, 2.267%, 40)
$130,586
(c) Continuously
Payment period :
A = $5,000
Quarterly
Interest Period:
0
Continuously
1 2 40 Quarters
Adjusted Balance The bank subtracts the amount of Your beginning balance is $3,000.
your payment from the beginning With the $1,000 payment, your
balance and charges you interest new balance will be $2,000. You
on the remainder. This method pay 1.5% on this new balance,
costs you the least. which will be $30.
Average Daily Balance The bank charges you interest on Your beginning balance is $3,000.
the average of the amount you With your $1,000 payment at the
owe each day during the period. 15th day, your balance will be
So the larger the payment you reduced to $2,000. Therefore,
make, the lower the interest you your average balance will be
pay. (1.5%)($3,000+$2,000)/2=$37.50.
Previous Balance The bank does not subtract any Regardless of your payment size,
payments you make from your the bank will charge 1.5% on your
previous balance. You pay beginning balance $3,000:
interest on the total amount you (1.5%)($3,000)=$45.
owe at the beginning of the
period. This method costs you the
most.
41
ApplicationsLoan Analysis
$20,000
1 2 24 25 48
0
1 2 24 25 48
0
$492.97 $492.97
25 payments that were 23 payments that are
already made still outstanding
Debt Financing:
Pdebt = $2,000 + $372.55(P/A, 0.5%, 36)
- $8,673.10(P/F, 0.5%, 36)
= $6,998.47
Lease Financing:
Please =$731.45) + $236.45(P/A, 0.5%, 35)
+ $300(P/F, 0.5%, 36)
= $8,556.90
Summary