credits

Interest Rate Formulas

If you put a sum of money in the bank and let the interest accumulate, the amount of money you will have some time in the future is given by the formula where P is the initial investment, r is the interest rate per period, t is the number of periods, and A is the amount of money in the bank after the t periods. If you know any three of the four numbers A,P,r,t you can solve for the fourth by using the following formulas
ln(A/P) ln(1+r) log(A/P) log(1+r) .
Note that you can use log instead of ln in the calculation for t; you will get the same number even though the numerator and denominator of the fraction will be different. If you want to know how inflation affects the value of your money, the formula will determine this. Here, P is the present value of your money and F is the future value of your money. Now, r is the inflation rate per period and t is the number of periods. In other words, P dollars in today's dollars is equivalent to F dollars after t periods in the future. If you want to know how much money was worth in the past, use where F is the current value of your money and P is the equivalent in past dollars. If you are taking out a loan, use the following formula The amount you borrow is L, the interest rate per period is r, the number of periods is t, and P is the payment per period. If you know what you can make in payments, at what rate you will get, then you can determine how much you can borrow with the formula which we get from the previous formula by solving for L. If you change your payments to a new payment P ¢ , you can determine the new number of periods by the formula
t ln(1+r) log(1+r)
For annuities, the formulas are similar as those for loans. If you need a certain amount of money in the future and want to put away some money every month (or in some other frequency), the formula is where P is how much you put in the bank each period, r is the interest rate per period, t is the number of periods, and A is how much money you need in the future. If you know how much you wish to invest each period and want to find out how much money you have in the future, we solve this formula for A to get Keep in mind that inflation will eat away at your money, so if you need $10,000 now, you will need more 20 years from now. If you have an amount of money invested and you receive regular payments from this investment, the appropriate formula is the same as the loan formula, where P is your income per period, A is the amount of money you started with in the bank, r is the interest rate per period, and t is the number of payments you receive. If you know the amount to invest and you want to determine the amount of money you started with, use If you have a perpetual annuity, one that pays you without a fixed ending date, then your payment is given by the equation This is the same as if you have an amount A of money in the bank collecting interest at a rate of r, and you withdraw the interest each period. If you have a desired income P, you can

find out how much money A you need in the bank by using the formula A = P/r. To help you use these formulas, here are a few examples.

Example 1.

If you invest $1,000 in the bank at 6%, compounded yearly, after 7 years you have If the interest rate is compounded monthly instead of yearly, then in 7 years you have

1000(1+.06/12)84 = $1520.37. 
If you hoped to have $1,750 in the bank 7 years later, you need a yearly interest rate of
r = (1750/1000)1/7-1 = .083, 
or 8.3%. On the other hand, if your interest rate was 7.5% compounded monthly, the amount of time it will take for your $1,000 to increase to $1,750 is
t ln(1750/1000) ln(1+.075/12) = 89.8, 
and this number is in months since our interest rate, which is .075/12, is the yearly rate of 7.5% converted into a monthly rate. Therefore, it takes 89.8/12 = 7.48 years, or almost 7 and a half years, for this to happen.

Example 2. 

You need $75,000 now to send your kid through college. However, he or she won't go to college for 12 more years, and the college estimates its tuition and other expenses will rise at the rate of 9% per year. Thus, in 12 years you will need

75000(1+.09)12 = $210,949.86 
for college expenses.

For another example, suppose inflation in the last fifty years has averaged 3%. If you can buy a house today for $100,000, what would be the equivalent amount in 1935 dollars? This value is

100000(1+.03)-50 = $22,810.70, 
so, at this rate of inflation, a house costing $22,811 fifty years ago would cost $100,000 today.

Example 3.

You need $50,000 to buy a used Jaguar, but you only have $5,000 for a down payment. If the bank will loan you the rest at 11% for a five year loan, then your monthly payment will be

45000(.11/12) (1-(1+.11/12)-60) = $978.41 
Note that we had to convert the interest rate to a monthly rate. Also, five years has 60 months, so you will make 60 payments of $978.41. If you are able to pay $1,050 each month, you will pay off the loan in
ln æ
ç
è
1050 1050-45000(.11/12) ö
÷
ø
ln(1+.11/12)
= 54.7, 
or in just under 55 monthly payments. At $978.41 for 60 months you pay a total of $978.41·60 = $58,704.60, while at $1,050 for 55 months you pay a total of $1,050·55 = $57,750.00. So, you save about $1,000 over the life of the loan.

Example 4. 

To get back to the college expenses problem, you need to have approximately $211,000 in 12 years for your kid's college expenses. If you can invest money each month at an 8% yield, each month you need to deposit

211000(.08/12) ((1+.08/12)144-1) = $877.31. 
Again, we had to convert the interest rate to a monthly rate and use the number of months in 12 years.

Example 5.

You have saved for your retirement, and today you have $400,000 in your retirement plan. If your plan is earning 4% interest per year, and you want to receive monthly payments for the next 20 years, you will receive

400000(.04/12) (1-(1+.04/12)-240) = $2,423.92 
each month. If you only want to receive money for 15 years you will receive
400000(.04/12) (1-(1+.04/12)-180) = $2,958.75 
per month. However, if you wish to receive a perpetual annuity, you will receive
400000(.04/12) = $1,333.33 
each month.

File translated from TEX by TTH, version 1.95.
On 10 Dec 1998, 18:41.


Category: Annuity

Similar articles: