Week 12 MMW

10 The Mathematics of Money
10.1 Percentages
10.2 Simple Interest
10.3 Compound Interest
10.4 Geometric Sequences
10.5 Deferred Annuities: Planned Savings
for the Future
10.6 Installment Loans: The Cost of
Financing the Present
Copyright © 2010 Pearson Education, Inc. Excursions in Modern Mathematics, 7e: 10.2 - 2
Present Value and Future Value
Money has a present value and a future
value. Unless you are lending money to a
friend, if you invest $P today (the present
value) for a promise of getting $F at some
future date (the future value), you expect F
to be more than P. Otherwise, why do it?
The same principle also works in reverse. If
you are getting a present value of P today
from someone else (either in cash or in
goods), you expect to have to pay a future
value of F back at some time in the future. If
we are given the present value P, how do
we find the future value F (and vice versa)?
Interest Rate
The answer depends on several variables,
the most important of which is the interest
rate. Interest is the return the lender or
investor expects as a reward for the use of
his or her money, and the standard way to
describe an interest rate is as a yearly rate
commonly called the annual percentage
rate (APR).
Thus, we can say, “I am investing my
money in an account that pays an APR of
5%,” or “I have to pay a 24% APR on the
balance on my credit card.”
Simple Interest or Compound Interest
The APR is the most important variable in
computing the return on an investment or
the cost of a loan, but several other
questions come into play and must be
considered. Is the interest simple or
compounded? If compounded, how often is
it compounded? Are there additional fees? If
so, are they in addition to the interest or are
they included in the APR? We will consider
these questions in Sections 10.2 and 10.3.
Simple Interest
In simple interest, only the original money

invested or borrowed (called the principal)
generates interest over time. This is in
contrast to compound interest, where the
principal generates interest, then the
principal plus the interest generate more
interest, and so on.
Example 10.7 Savings Bonds
Imagine that on the day you were born your
parents purchased a $1000 savings bond that
pays 5% annual simple interest. What is the
value of the bond on your 18th birthday?
What is the value of the bond on any given
birthday? Here the principal is P = $1000 and
the annual percentage rate is 5%. This
means that the interest the bond earns in one
year is 5% of $1000, or (0.05)$1000 = $50.
Because the bond pays simple interest, the
interest earned by the bond is the same every
year.
Example 10.7 Savings Bonds
Thus,
■ Value of the bond on your 1st birthday
= $1000 + $50 = $1050.
■ Value of the bond on your 2nd birthday
= $1000 + (2  $50) = $1100
…
■ Value of the bond on your 18th birthday
= $1000 + (18  $50) = $1900 .
■ Value of the bond when you become
t years old = $1000 + (t  $50).
SIMPLE INTEREST FORMULA
The future value F of P dollars invested

under simple interest for t years at an
APR of R% is given by
F = P(1 + r • t)
(where r denotes the R% APR written as

a decimal).
Simple Interest
You should think of the simple interest
formula as a formula relating four variables:
P (the present value), F (the future value), t
(the length of the investment in years), and r
(the APR). Given any three of these
variables you can find the fourth one using
the formula. The next example illustrates
how to use the simple interest formula to
find a present value P given F, t, and r.
Example 10.8 Government Bonds:
Part 2
Government bonds are often sold based on
their future value. Suppose that you want to
buy a five-year $1000 U.S.Treasury bond
paying 4.28% annual simple interest (so that
in five years you can cash in the bond for
$1000). Here $1000 is the future value of the
bond, and the price you pay for this bond is
its present value.
Example 10.8 Government Bonds:
Part 2
To find the present value of the bond, we let
F = $1000, R = 4.28%, and t = 5 and use the
simple interest formula. This gives
$1000 = P[1 + 5(0.0428)] = P(1.214)
Solving the above equation for P gives
$1000
P  $823.72
1.214
(rounded to the nearest penny).
Credit Cards
Generally speaking, credit cards charge

exceptionally high interest rates, but you
only have to pay interest if you don’t pay
your monthly balance in full. Thus, a credit
card is a two-edged sword: if you make
minimum payments or carry a balance from
one month to the next, you will be paying a
lot of interest; if you pay your balance in full,
you pay no interest.
Credit Cards
In the latter case you got a free, short-term

loan from the credit card company. When
used wisely, a credit card gives you a rare
opportunity–you get to use someone else’s
money for free. When used unwisely and
carelessly, a credit card is a financial trap.
Example 10.9 Credit Card
Use: The Good, the Bad
and the Ugly
Imagine that you recently got a new credit
card. Like most people, you did not pay much
attention to the terms of use or to the APR,
which with this card is a whopping 24%. To
make matters worse, you went out and spent
a little more than you should have the first
month, and when your first statement comes
in you are surprised to find out that your new
balance is $876.
and the Ugly
Like with most credit cards, you have a little
time from the time you got the statement to
the payment due date (this grace period is
usually around 20 days). You can pay a
minimum payment of $20, the full balance of
$876, or any other amount in between. Let’s
consider these three different scenarios
separately.
and the Ugly
■ Option 1: Pay the full balance of $876
before the payment due date. This one is
easy. You owe no interest and you got free
use of the credit card company’s money for
a short period of time. When your next
monthly bill comes, the only charges will be
for your new purchases.
and the Ugly
■ Option 2: Pay the minimum payment of
$20. When your next monthly bill comes,
you have a new balance of $1165
consisting of:
1. The previous balance of $856. (The $876

you previously owed minus your payment
of $20.)
and the Ugly
2. The charges for your new purchases. Let’s
say, for the sake of argument, that you
were a little more careful with your card
and your new purchases for this period
were $288.
and the Ugly
3. The finance charge of $21 calculated as
follows:
(i) Periodic rate = 0.02
(ii) Balance subject to finance charge
= $1050
(iii) Finance charge = (0.02)$1050 = $21
You might wonder, together with millions of
other credit card users, where these numbers
come from. Let’s take them one at a time.
and the Ugly
(i) The periodic rate is obtained by dividing
the annual percentage rate (APR) by the
number of billing periods. Almost all credit
cards use monthly billing periods, so the
periodic rate on a credit card is the APR
divided by 12. Your credit card has an
APR of 24%, thus yielding a periodic rate
of 2% = 0.02.
and the Ugly
(ii) The balance subject to finance charge
(an official credit card term) is obtained by
taking the average of the daily balances
over the previous billing period. Since this
balance includes your new purchases, all
of a sudden you are paying interest on all
your purchases and lost your grace
period! In your case, the balance subject
to finance charge came to $1050.
and the Ugly
(iii) The finance charge is obtained by
multiplying the periodic rate times the
balance subject to finance charge. In this
case, (0.02)$1050 = $21.
■ Option 3: You make a payment that is

more than the minimum payment but less
than the full payment.
Let’s say for and the Ugly
the sake of argument that you
make a payment of $400. When your next
monthly bill comes, you have a new balance
of $777.64. As in option 2, this new balance
consists of:
1. The previous balance, in this case $476
(the $876 you previously owed minus the
$400 payment you made)
2. The new purchases of $288
and
3. The finance the Ugly
charges, obtained once again
by multiplying the periodic rate (2% = 0.02)
times the balance subject to finance
charges, which in this case came out to
$682.
Thus, your finance charges turn out to be
(0.02)$682 = $13.64, less than under option
2 but still a pretty hefty finance charge.
Two Important Lessons
1. Make sure you understand the terms of
your credit card agreement.
Know the APR (which can range widely
from less than 10% to 24% or even
more), know the length of your grace
period, and try to understand as much of
the fine print as you can.
Two Important Lessons
2. Make a real effort to pay your credit card
balance in full each month.
This practice will help you avoid finance
charges and keep you from getting
yourself into a financial hole. If you can’t
make your credit card payments in full
each month, you are living beyond your
means and you may consider putting
your credit card away until your balance
is paid.

Week 12 MMW

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Week 12 MMW

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10 The Mathematics of Money

In simple interest, only the original money

The future value F of P dollars invested

(where r denotes the R% APR written as

Generally speaking, credit cards charge

In the latter case you got a free, short-term

1. The previous balance of $856. (The $876

■ Option 3: You make a payment that is

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