Applied Math Practice for Financial Advisors

Course Instructor - Meeyeon

About Meeyeon...
Prior to joining CFI, Meeyeon lived in Toronto for 10
years, where she worked in traditional financial
services roles, such as investment banking and
portfolio management. Meeyeon was on a mission
to find a professional career that felt more tangible,
meaningful, and impactful. In her search for ‘more,’
she switched gears from Investment Banking and
explored career paths in applied finance within a
large global consumer corporation and consulted at
an impact venture capital firm before joining the CFI
team in Vancouver, BC.

Meeyeon Park
Director, Financial Planning &
Wealth Management

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Learning Objectives

Apply time value of money Calculate returns on deposits with Calculate costs on loans with and
concepts to retail banking and and without compounding without compounding
financial planning situations

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Course Introduction
This course assumes that you have a solid working knowledge of some basic time value of money concepts.

Math Fundamentals for Capital Markets

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Course Introduction

What we are not doing What we are doing

Deep, narrow, and specialized expertise Review and application of the key concepts

Calculus, geometry, derivatives Math-oriented finance concepts

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Course Outline

Simple vs. Time Value

Annuities
Compound Interest of Money

Apply all the concepts to the two large purchase decisions that are often
made with financing:

1. Buying a house with a mortgage

2. Buying a car with a loan

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Simple vs. Compound Interest
Variables

P Principal ($): The initial amount of money you want to invest

I Interest earned ($): What you get in return for your investment

A Accumulated amount ($): The total amount (principal plus interest)

r Interest rate (%): How fast you will be accumulating interest

t Time (years): How long you will keep your investment

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Simple Interest

Simple Interest Compound Interest

Simple interest is not very commonly found anymore

because you don’t earn as much money.
Simple vs. Compound Interest
Compound Simple
Principal
$

Interest Interest Interest

Time You will not be paid interest on the interest you are
earning along the way.

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Simple Interest

Simple Interest Compound Interest

I=P×r×t Year Principal (P) Interest (I)

Variables:
I = $1,000 × 4% × 3
Today $1,000
P = $1,000 I = $40 × 3
r = 4% 1 +$40
I = $120
t = 3 years 2 +$40
A=P+I
3 +$40
A = $1,000 + $120
A = $1,120 Total $1120

Principal (P) Interest Earned (I) Accumulated Amount (A)

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Compound Interest

Simple Interest Compound Interest

Simple Interest Year 1 Year 2 Year 3

This time, we are
P = $1000 offered an annual
I2 is calculated by
r = 4% compound
t = 3 years using P2
interest rate of
4%.
Interest earned (I)
I=P×r×t P1 P2 P3
I = 1000 × 4% × 3 I1 I2 I3
I = $120

Accumulated amount (A)

A=P+I Add P1 and I1 together Add P2 and I2 together
A = $1,000 + $120 and you have P2 and you have P3
A = $1,120

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Compound Interest

Simple Interest Compound Interest

Simple Interest Year 1 Year 2 Year 3

P = $1000
r = 4% I1 = P1 × r I2 = P2 × r I3 = P3 × r
t = 3 years
𝐈𝟏 = $1,000 × 4% 𝐈𝟐 = $1,040 × 4% 𝐈𝟑 = $1,081.60 × 4%
Interest earned (I) 𝐈𝟏 = $40.00 𝐈𝟐 = $41.60 𝐈𝟑 = $43.26
I=P×r×t
I = 1000 × 4% × 3 P2 = P1 + I1 P3 = P2 + I2 A = P3 + I3
I = $120
𝐈𝟏 = $1000 + $40.00 𝐈𝟏 = $1,040 + $41.60 A = $1,124.86
Accumulated amount (A) 𝐈𝟏 = $1,040 𝐈𝟏 = $1,081.60
A=P+I
A = $1,000 + $120
A = $1,120

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Compound Interest

Simple Interest Compound Interest

Interest Running
Compound Interest Year Principal Interest
Accumulated Balance

P = $1000 Today $1,000.00 $1,000.00

r = 4%
1 $1,000.00 +$40.00 $40.00 $1,040.00
t = 3 years
2 $1,040.00 +$41.60 $81.60 $1,081.60

3 $1,081.60 +$43.26 $124.86 $1,124.86

Total $1,124.86

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Simple vs. Compound Interest

Simple vs. Compound Interest

Compound Simple
$120 $124.86
$

Interest Earned Interest Earned

(Simple) (Compound)

The impact of more frequent

Time
compounding periods of interest, larger
initial pot of money, and a longer time
horizon can have incredible effects. The impact of compound interest is an
exponential growth.

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Simple vs. Compound Interest

Spread of COVID-19 Simple vs. Compound Interest

Compound Simple

Time

The impact of compound interest is an

exponential growth.

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Time Value of Money
Time Value of Money

Option 1

• $100k annual salary

• 80% bonus at year-end

Money today is better than

money tomorrow.
Option 2

• $180k annual salary

• No bonus

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Time Value of Money

Opportunity Cost Inflation Uncertainty

Purchasing Power Default Risk

Spend the cash Things could get more Someone may default on
expensive a year from the money they owe
Invest the cash now. you.

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Future Value & Present Value in a Simple Interest World

Your local bank offers a simple You should always have a good
annual interest rate of 10%. sense of what the rates are.

You have $2,000 saved up. Present Value (PV) = $2,000

You deposit the money to the high-

interest savings account that offers a Interest Rate (r) = 10%
simple annual interest of 10%.

You are saving it for college that starts Time (t) = 2 years
2 years from now.

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Future Value & Present Value in a Simple Interest World

Present Value (PV) = $2,000 Interest Rate

V (r) = 10% Time (t) = 2 years

Interest Earned (I) = PV (r × t)

Interest Interest
= $2,000 (10% × 2 years) Year Principal
Earned Accumulated
= $400
1 +$200 $200
Accumulated Amount (A) = PV + I
= $2,000 + $400 2 +$200 $400 $2,000

= $2,400 Total $2400

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Future Value & Present Value in a Simple Interest World

Future Value (FV) = Present value (PV) x [1 + (r × t)]

Your goal:

Have $2,4000 at the end of 2 years. FV

PV =
1 + (r × t) Discount Factor

How much money will you have to start off $2,400

PV =
with to achieve this? 1 + (10% × 2)

Deposit into the high-interest savings account

$2,400
that offers 10% simple annual interest. PV = Discount Factor
1.2

PV = $2,000

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Effective Rate vs. Nominal Rate

Simple interest is not very commonly found nowadays.

People and businesses offer compound interest.

Deposit your cash Purchase with credit card

“Deposit your money with us “Use our credit cards with a low
today and earn an effective rate, annual percentage rate (nominal
an annual percentage yield of rate) of 21.5%?”
10%.”

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Effective Rate vs. Nominal Rate
Simple Compound

• Nominal Rate • Effective Rate

V
• Annual Percentage Rate (APR) • Effective Annual Rate (EAR)
S
• Annual Percentage Yield (APY)

The interest rate has not taken into account The interest rate has taken compounding
any compounding. into consideration.

When depositing your funds, the When borrowing funds, the credit
bank is paying you a rate slightly less card issuer advertises a nominal rate
than the 10% of effective rate. that is lower than the cost of
borrowing.

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Effective Rate vs. Nominal Rate

Convert Nominal Rate to Effective Rate Convert Effective Rate to Nominal Rate

Nominal Interest Rate (rnom) 10.00% Effective Annual Rate (reff) 10.38%

# of Compounding Periods (f) 4 # of Compounding Periods (f) 4

rnom f 1
reff = (1 + ) −1 rnom = −𝟏 xf
f f
reff + 1
reff = 10.38
= 10%

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Effective Rate vs. Nominal Rate

“Deposit your money with us today and “Use our credit cards with a low annual
earn an effective rate, an annual percentage rate (nominal rate) of
percentage yield of 10%.” 21.5%?”

What you actually pay What you actually pay

Nominal Rate ? Nominal Rate 21.5%
Compounding Period Monthly Compounding Period Monthly
Effective Annual Rate 10% Effective Annual Rate ?

Nominal Rate: 9.57% Effective Rate: 23.75%

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Effective Rate vs. Nominal Rate

If you are borrowing money If you are lending money

You want as minimal You want as much

compounding as possible. compounding as possible.

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Future Value & Present Value in a Compound Interest World
Time in Payments to Interest that your Accumulated
Years Grandfather Grandfather pays you Balance
Example: r
(A) (B) (C) = (B) × (D)
f
• Present Value (PV) = $100 Today $100.00 - $100.00

0.5 $100.00 $100 x 2.50% = $2.50 $102.50

• Interest Rate (r) = 5%
1.0 $102.50 $102.50 x 2.50% = 2.56 $105.06
• Frequency (f) = 2
1.5 $105.06 $105.06 x 2.50% = $2.63 $107.69

• Time (t) = 3 years 2.0 $107.69 $107.69 x 2.50% = $2.69 $110.38

2.5 $110.38 $110.38 x 2.50% = $2.76 $113.14

r t×f 3.0 $113.14 $110.38 x 2.50% = $2.83 $115.97

FV = PV × 1+
f
3×2
5%
FV = 100 × 1+
2

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Annuities
Annuities Overview

A series of equal At equal time For a fixed

payments periods number of years

Annuities

Home Mortgage Retirement Income Auto Loan

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Annuities Overview

• Interest rate

Annuity Factor: The total of the discount factors in each period • Frequency

• Intervals between payments

Example: What is the present value of a $1,000

annuity for 3 years at 3% annual compounding?
Year Discount Factor
Annuity Factor: 2.829
1
Present Value: $1,000 x 2.829 = $2,829 1 = 0.9709
(1 + 3%) 1

1 1
1− 2
PV Annuity Factor = 1+r n (1 + 3%) 2
= 0.9426
r
• r: rate per period 1
3 = 0.9151
(1 + 3%) 3
• n: number of periods

Note: In this case, n is the same as years (t) Sum 2.829

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Auto Loan Example

Your commute: What will be your monthly payments?

Open the Excel file called Applied Math Practice

for Financial Advisors - Exercises (Blank) and
complete the Auto Loan worksheet. Once you
give it a try, watch the next video for a
By bus: 3 hours vs. By car: 40 minutes
walkthrough.

Car price: $12,000

Down payment: $2,400 (20%).

Loan: $9,600

Rate: 3% APR compounded monthly

Term: 3 years (36 months)

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Auto Loan Example
Present Value of an Annuity Formula
Vehicle Information 1
1−
Principal = Payment × 1+r n
Used car price: $12,000 r

Contributions
Loan Amount Monthly Payment
Down payment: $2,400

Loan Details
Loan Amount $9,600 $9,600
Monthly
Loan amount: $9,600 = = = = $279.23
Payment 1 1 34.38
1− 1−
Annual rate: 3.0% 1+r n 1 + 0.25% 36
r 0.25%
3.0%
Monthly rate (r): = 0.25%
12
Number of periods (n):
12 months x 3 years = 36

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Auto Loan Example

Vehicle Information
Loan Amount $9,600 $9,600
Used car price: $12,000 Monthly
= = = = $279.23
Payment 1 1 34.38
1− 1−
1+r n 1 + 0.25% 36
Contributions
r 0.25%
Down payment: $2,400

PV Annuity Factor
Loan Details

Loan amount: $9,600 34

Annual rate: 3.0% Approximately the # of payments it takes to repay the principal

3.0%
Monthly rate (r): = 0.25%
12
36 - 34 = 2
Number of periods (n):
Approximately the # of payments it takes to pay the interest
12 months x 3 years = 36

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Auto Loan Example

Moderate loan - $9,600 Big loan - $1,000,000

Short term – 3 years Long term – 25 years

As a financial advisor, it is important to understand the impact of moving rates on a client’s

portfolio and financial plan.

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Mortgage

A mortgage is the annuity of a lifetime.

It is the concept that ties together the fundamental math you need to know.

Why are Mortgages so important?

How the product is calculated and priced
As an advisor, almost every client you have
will either have or have had one or
multiple mortgages in their life.
How the variables can impact the cashflows

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Mortgage Example

For Sale: $2,390,000 What will be your monthly payments?

Open the Excel file called Applied Math Practice

Key Inputs
Purchase Price $2,390,000.00
Down Payment $717,000.00
for Financial Advisors - Exercises (Blank) and
complete the Mortgage worksheet. Once you
give it a try, watch the next video for a
walkthrough.

Mortgage Amount $1,673,000.00

Interest Rate 5-year fixed at 5.25%

Compounding Period Semi-annual

Amortization Period 25 years

Payment Frequency Monthly

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Mortgage – Example 1

1
Property Information 1−
Present Value of an
Principal = Payment × 1+r n
Annuity Formula r
Listing Price: $2,390,000

Contributions Mortgage Monthly Payment

Down Payment (30%): $717,000

Loan Amount $1,673,000 $1,673,000

Monthly
Mortgage Financing = = = = $10,025
Payment 1 1 166.875
1− 1−
1+r n 1 + 0.4375% 300
Mortgage: $1,673,000
r 0.4375%
Annual interest rate: 5.25%
5.25%
Monthly rate (r): = 0.4375%
12
Number of periods (n):
Interest % ? Principal % ?
12 months x 25 years = 300

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Mortgage – Example 1

The composition of your monthly

mortgage payment changes over time Interest is calculated on period
A
opening balance
5.25%
Opening Interest Principal Total Ending $1,673,000 x = $7,319
12
Month Balance Payment Payment Payment Balance

0 - - - - 1,673,000
A B B Principal repayment is the difference
1 1,673,000 7,319 2,706 10,025 1,670,293 between total payment and interest
C
2 1,670,293 7,307 2,717 10,025 1,667,576 $10,025 - $7,319 = $2,706

… … … … … …
Ending Balance is opening balance
299 19,920 10,025 9,981 C
minus only the principal
300 9,981 Paid off! $1,673,000 – $2,706 = $1,670,293

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Mortgage – Example 1

Property Information

Listing Price: $2,390,000 Loan Amount $1,673,000 $1,673,000

Monthly
= = = = $10,025
Payment 1 1 166.875
Contributions 1− 1−
1+r n 1 + 0.4375% 300
Down Payment (30%): $717,000 r 0.4375%

Annuity Factor
Mortgage Financing

Mortgage: $1,673,000
Total payments: 25 years x 12 months = 300
Annual interest rate: 5.25%
5.25%
• 167 are going towards paying back your principal.
Monthly rate (r): = 0.4375%
12
• 133 are going towards interest.
Number of periods (n):
12 months x 25 years = 300

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Mortgage – Example 1

Mortgage Payment – Composition of Interest vs. Principal

Interest Pmt Principal Pmt

100%

80%

60%

40%

20% A large portion of your initial monthly

payments is interest.

0% Time

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Mortgage – Example 2

Fixed rate mortgage: one of the most Down payment: typically required, same
common types of mortgages with most other asset-based loans

Home price: $600,000

Down payment: $600,000 x 20% = $120,000

After we complete the example,
try to calculate again using your
Mortgage amount: $600,000 - $120,000 = $480,000
local figures.
Interest Rate: 5-year, closed 5.0%

Amortization period: 20 years

Payment frequency: Monthly

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Mortgage – Example 2

Fixed rate mortgage: one of the most

common types of mortgages

Home price: $600,000

Down payment: $600,000 x 20% = $120,000

Mortgage amount: $600,000 - $120,000 = $480,000 Present Value

Interest Rate: 5-year, closed 5.0% We are guaranteed the interest rate for 5 years

Amortization period: 20 years Total # of Payments: 20 x 12 = 240

Payment frequency: Monthly

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Mortgage – Example 2

Present Value: $480,000

Total # of Payments: 240 (monthly)

Interest rate: 5% (compounded semi-annually)

There’s a misalignment that we need to

adjust for.

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Mortgage – Example 2

Step 1 – Calculate the EAR (Effective Annual Rate)

rnom f
EAR = (1 + ) −1
Nominal Interest rate (rnom): 5% f
5% 2
= (1 + ) − 1 = 5.06%
Compounding Period: semi-annually 2

# of Compounding Periods (f): 2

Step 2 – Calculate monthly compounded interest rate
Monthly compounded interest rate
5.06% = (1+rmonthly)12 - 1

1
rmonthly = 1 + 5.06% 12 − 1

= 0.4124%

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Mortgage – Example 2

Mortgage
Monthly Payment =
Mortgage: $480,000 1
1−
1+r n
r
Monthly Compounded rate (r): 0.4124%

$480,000
Total # of Payments (n): 240 (monthly) =
1
1−
1 + 0.4124% 240
0.4124%

= $3,154

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Keep Practicing

Keep practicing using the extra worksheets in the Applied

Math Practice for Financial Advisors – Exercises file.

• Saving Deposit

• Investing for Retirement

• Interest Only Loan

• Revolving Balance

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