2/10/2015

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?

An interest rate takes two forms

nominal interest rate per year : is the annual interest
rate without considering the effect of any
compounding (r)


effective interest rate per year: is the annual interest
rate taking into account the effect of any compounding
during the year (ia)

Nominal Interest Rate:
Effective Interest Rate:

Interest rate quoted based Actual interest earned or
on an annual period
paid in a year or some other
time period

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Annual interest rate computed as the

product of interest rate per period and the
number of periods per year
Interest rates are normally quoted on an
annual basis
Or Compounding several times within a year:






Semiannually
Quarterly
Monthly
Weekly
Daily

What It Really Means?

Interest rate per month (i) =
18%/12 = 1.5%

Number of interest periods per
year (N) = 12

In words,

Bank will charge 1.5% interest
each month on your unpaid
balance, if you borrowed money.

You will earn 1.5% interest each
month on your remaining
balance, if you deposited money.

Question: Suppose that

you invest $1 for 1 year
at 18% compounded
monthly. How much
interest would you earn?

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Example:

18% compounded
monthly

Formula:

r = nominal interest rate per

year
ia = effective annual interest rate
M = number of interest periods
per year

What It really Means

1.5% per month for 12
months or

19.56% compounded
once per year

Solution:
Suppose your savings
account pays 9% interest
compounded quarterly.
quarterly.
a.
Interest rate per
quarter
b. Annual effective
interest rate (ia)
c.
If you deposit
$10,000 for one
year, how much
would you have?

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A loan shark lends money on the following terms :If I give you
50$ on Monday, you owe me $60 on the following Monday.
(a) What nominal interest rate per year (r) is the loan shark
charging
(b) What effective interest rate per year (ia) is he charging?
(c) If the loan shark started with $50 and was able to keep it, as
well as all the money he received, out in loans at all times, how
much money would he have at the end of one year?

C = number of interest periods per

payment period

K = number of payment periods per year

CK = total number of interest periods per
year, or M

r/K = nominal interest rate per payment period

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Suppose that you make a quarterly deposits

into a saving account that earns 12% interest
compounded monthly. Compute the effective
interest rate per quarter.
i= (1+r/M)C -1
.
.
= 3.03 %

12% compounded monthly

Payment Period = Quarter; Compounding Period = Month

1st Qtr

2nd Qtr

3rd Qtr

4th Qtr

1% 1% 1%
3.030 %

One-year
Effective interest rate per quarter
Effective annual interest rate

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Effective Interest Rate per Payment

Period with Continuous Compounding

Formula: With
continuous
compounding

Example:
Example: 12% compounded
continuously


(a) effective interest rate per

quarter

(b) effective annual interest

rate

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Compounding period equal to payment

period
(M=K)
This type of problems could be solved as
follows:
1- Identify the number of compounding (or
payment) periods (M=K) per year
2- Compute the effective interest rate per
payment period
i= r/M
3- Determine the number of payment periods.
N= M x ( number of years).

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Suppose you want to buy a car. You surveyed the

dealers, news paper advertisements, and the one
bellow has caught your attention.
8.5% annual percentage rate 48 months financing
Price starting as low as $21,599
Sales tax 1% for dealers freight = $215.99
4% sales tax = $863.96
Total purchasing price = $22,678.95
You can afford $2,678.95 as a down payment
What would be the monthly payment?
After a 25th payment, you want to pay off the remaining loan in a lump
sum amount . What is the required amount of this lump sum?

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 (A)

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$20,000
1

48

A
Given: P = $20,000, r = 8.5% per year
K = 12 payments per year
N = 48 payment periods

Find A:

Step 1: M = 12

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

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1-

2


34-

Could be computed as follows:

Identify the number of compounding periods per
year (M), the number of payment periods per year
(K), and the number of interest periods per payment
period (c).
Compute the effective interest rate per payment
period:
For discrete compounding, compute i= (1+r/M)C -1
For continuous compounding, compute i=er/K-1
Find the total number of payment periods: N=K x
(number of years)
Use i and N in the appropriate formulas

A series of equal
quarterly payments of
$5,000 for 10 years is
equivalent to what
present amount at an
interest rate of 9%
compounded
(a) quarterly
(b) monthly
(c) continuously

A = $5,000

0
12

40
Quarters

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A = $5,000

Payment period :
Quarterly
Interest Period:
Quarterly

40

12

A = $5,000


0
1 2

Payment period :
Quarterly
Interest Period:
Monthly

40

10

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A = $5,000


0
1 2

Payment period :
Quarterly
Interest Period:
Continuously

40

11