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 Times Rate per
Credited Credited compounding
per year period
Annual year 1 R
Semiannual 6 months 2 R
2
Quarterly quarter 4 R
4
Monthly month 12 R
12
 13.1 Compound Interest
• Compound interest formula:
M  P(1  i) n
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 2010 2020

$1000 $1000 $1000(1  i) n
 $1000
(1  i) n
(1.05)10  $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 365n
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 2010 2020

$1000 $1000 $1000e yr
yr
 10(.05) $1000
e e  $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 365n
)
365

 $2900(1  5% 3650
365
)
 $4781.13
 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
yr

 $2893.08
I  M  P  $2893.08  $1200
 $1693.08
 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 3½ %
compounded daily. Find his amount of interest.

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

compounded daily M  P(1  i )365n
365

 $6000(1  3365
.5% 365
)
 $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
compounded annually? M  P (1  i ) n

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 4
 $2173.81
(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
 P1.02 
20
4
)
3800
P 20
 $2557.29  $3800 in 5 years
(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% 28  1  1.03516  1 

$50,000  R    R  
 0.035 
 
7%
2  
50,000  20.97103R
50000
R  $2384.24
20.97103
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  1.05n  1 
$21,000  $1500   1500 

 
10%
2  0.05 
21,000 
 14  
1.05  1 
n


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 n 
 R  an i
 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 
 .051.05 
 .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 40 
 3000 
 .0251.025   .0671266 
 $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
 1  i   1
n
sn i

• 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 
 1  i n
 1  (1.035 )15
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-of-
period 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 50 
 12,000 
 .0351.035   0.195472 
 $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
RS  281,468.06 
1  i   1
n
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 = 10246.930 = $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
4. Get: Finance charge
 $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
(2)
Financed Charge payments  $100 
1
$345 $24.62 12 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.
Principal Interest Time in days Partial payments
$5800 10% 120 $2500 on day 60

1. Find the simple interest for 60 days and subtract it

from the payment.
60
I  PRT  $5800  0.10   $96.67
360
2. Subtract it from the payment:
$2500  96.67  $2403.33
3. Reduce the principal by the amount from (2)
$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):
3396.67  56.61  $3453.28
Total interest paid on the note (add interest paid to
interest due at 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 n 
so R  A 
 1  i   1
n
 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?

 i 1  i n   .09(1.09) 4 
R  A   $3500 
 1  i n
 1   (1.09) 4
 1 
 $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
 (1.01)  1
24

f .c.  24  225.95  4800  $622.80