Class Note for Sections 12.2, 12.3, 12.

4
MATH 175 E100
Stephen Choi
12.2 Compound Interest
If the interest earned is periodically added to the principal and thereafter
earns interest itself at the same interest rate, then it is called compound
interest.
Future Value for Compound Interest
A = P
_
1 +
r
m
_
n
Present Value for Compound Interest
P =
A
(1+
r
m
)
n
where
A is the future value in dollars
P is the principal in dollars
r is the annual interest rate expressed as a decimal
m is the number of compounding periods per year
t is the time in years
n is the total number of compounding periods and n = mt.
Example 1. Find the accumulated amount after 3 years if $1000 is invested
at 8% per year compounded (a) annually, (b) semiannually, (c) quarterly,
(d) monthly, and (e) daily.
Solution. Since
P = $1000 t = 3, t = 8% = 0.08
so using the formula
A = P
_
1 +
r
m
_
n
(a) annually, m = 1, A = $1000(1 + 0.08/1)
3
= $1259.71
(b) semiannually, m = 2, A = $1000(1 + 0.08/2)
(23)
= $1265.32
(c) quarterly, m = 4, A = $1000(1 + 0.08/4)
(43)
= $1268.24
(d) monthly, m = 12, A = $1000(1 + 0.08/12)
(123)
= $1270.24
(e) daily. m = 365, A = $1000(1 + 0.08/365)
(3653)
= $1271.22

1
Example 2. Find the present value of $49, 158.60 due in 5 years at an
interest rate of 10% per year compounded quarterly.
Solution. Use the formula
P =
A
_
1 +
r
m
_
n
with A = $49, 158.60, m = 4, r = 0.1, n = 5 4, we get
P = $
49, 158.60
_
1 +
0.1
4
_
45
= $30, 000.
Eective rate: The eective rate, r
e
, is the simple interest rate that
would produce the same accumulated amount in 1 years as the nominal rate
compounded m times a year. So we have
P
_
1 + r
e
_
= P
_
1 +
r
m
_
m
i.e
_
1 + r
e
_
=
_
1 +
r
m
_
m
i.e.
r
e
=
_
1 +
r
m
_
m
1
Example 3. Find the eective rate of interest corresponding to a nom-
inal rate of 8% per year compounded (a) annually, (b) semiannually, (c)
quarterly, (d) monthly, and (e) daily.
Solution. Since r = 0.08, so
(a) annually, m = 1, r
e
=
_
1 +
0.08
1
_
1
1 = 0.08
(b) semiannually, m = 2, r
e
=
_
1 +
0.08
2
_
2
1 = 0.0816
(c) quarterly, m = 4, r
e
=
_
1 +
0.08
4
_
4
1 = 0.08243
(d) monthly, m = 12, r
e
=
_
1 +
0.08
12
_
12
1 = 0.08300
(e) daily. m = 365, r
e
=
_
1 +
0.08
365
_
365
1 = 0.08328

Continuous Compounding of Interest: In general, if the number of com-

pounding periods per year is larger, then the interest earned is more. We
let m to the formula
A = P lim
m
_
1 +
r
m
_
mt
.
By using the known result that
lim
m
_
1 +
1
m
_
m
= e
so we get the continuous compound interest (that is compounding in-
terest at every moment) is
A = Pe
rt
where P is the principal in dollars; r is the annual interest rate; t is the
times in years and A is the future value in dollars at the end of t years.
Example 4. If P = $1000, r = 8% p.a. and t = 3. Then
(a) Compounding continuously
A = $1000e
0.083
= $1000e
0.24
= $1271.25
(b) Compounding daily
A = $1000
_
1 +
0.08
365
_
3653
= $1271.22.

Example 5. The market value of Blakelys property is

V (t) = 300, 000e

t
2
where V (t) is measured in dollars and t is the times in years from the present.
If the expected rate of ination is 9% compounded continuously for the next
10 years, nd the expression for the present value P(t) of the market price of
property valid for the next years. Compute P(7), P(8), P(9) and interpret
your results.
Solution.
P(t) = V (t)e
0.09t
= 300, 000e

t
2
0.09t
, 0 t 10.
So
P(7) = $300, 000e

7
2
0.09(7)
= $599, 837
P(8) = $300, 000e

8
2
0.09(9)
= $600, 640
P(9) = $300, 000e

9
2
0.09(9)
= $598, 115.
The optimal to sell the property is when t = 8.
12.3 Increasing Annuity
An annuity is a sequence of payments made at certain time intervals
over a specied length of time.
Some terminologies
Time interval is called period.
The total length of time in which these payments are made is called
term.
The individual payment is called rent R .
Equal payment that are made at the beginning of the payment period
is called annuity due.
Equal payment that are made at the end of the payment period is
called ordinary annuity.
In this section, we assume the annuity is ordinary, i.e., payment are made
at the end of payment period.
Increase Annuity: Regularly deposits to a savings account to build a fund
for the future.
Example 6. Suppose $1000 is deposited into a bank at the end of every
year for a term of 4 years with r = 0.08 compounded annually. Then
The future value of the $1000 at the end of the 1st year, A
3
, is
A
3
= 1000(1 + 0.08)
3
.
The future value of the $1000 at the end of the 2nd year, A
2
, is
A
2
= 1000(1 + 0.08)
2
.
The future value of the $1000 at the end of the 3rd year, A
1
, is
A
1
= 1000(1 + 0.08)
1
.
The future value of the $1000 at the end of the 4th year, A
0
, is
A
0
= 1000(1 + 0.08)
0
.
Therefore the total amount at the end of the 4th year is
A = A
3
+ A
2
+ A
1
+ A
0
= $
_
1000(1 + 0.08)
3
+ 1000(1 + 0.08)
2
+ 1000(1 + 0.08)
1
+ 1000(1 + 0.08)
0
_
= $4506.11.

Example 6 suggests the following formula

A = A
0
+ A
1
+ + A
n1
= R + R(1 + i) + R(1 + i)
2
+ + R(1 + i)
n1
= R
_
(1 + i)
n
1
(1 + i) 1
_
= R
_
(1 + i)
n
1
i
_
.
Therefore, we have the formula for the future value of an increasing
annuity of n period and rate i period and rent R is
A = R
_
(1+i)
n
1
i
_
= R s
n i
and the payment of an increasing annuity is
R =
A
(1+i)
n
1
i
=
A
s
n i
where s
n i
=
(1+i)
n
1
i
.
Example 7. A hospital is expecting renovation costs in excess of $500, 000
in 5 years. How much should the executive committee plan to deposit at the
end of each month into an account paying 5.85%p.a. compounded monthly,
so that there is enough money for the upgrading.
Solution. Find R by given that A = $500, 000, i = 0.0585/12 = 0.004875
and n = 5 12 = 60. So
R = $500, 000
_
(1.004875)
60
1
0.004875
_
1
= $7194.07.
12.4 Decreasing Annuity and Amortization
A monthly home mortgage pays o a loan charged with interest for a
property is a type of decreasing annuity.
Example 8. Suppose we want to retire at age 50 and be able to withdraw
$50000 at the end of each year for 30 years with interest rate 6%p.a.
Solution. First we compute that future value A in order to able to withdraw
$50000 at the end of each year for 30 years:
A = R
_
(1 + i)
n
1
i
_
= $50, 000
_
(1 + 0.06)
30
1
0.06
_
= $3, 952, 909.31.
The present value of A is
P = A(1 + i)
n
= $3, 952, 909.31(1 + 0.06)
30
= $688, 241.56.
Therefore, we need to deposit $688, 241.56 at the age 50.
Example 8 suggests the following formula
P(1 + i)
n
= R
_
(1 + i)
n
1
i
_
or
P = R
_
(1 + i)
n
1
i(1 + i)
n
_
= R
_
1 (1 + i)
n
i
_
.
Therefore the present value of a decreasing annuity is
P = R
_
1(1+i)
n
i
_
= R a
n i
and the payment of an increasing annuity is
R = P
_
1(1+i)
n
i
_
1
=
P
a
n i
where a
n i
=
1(1+i)
n
i
.
Example 9. Rachel is buying a family-sized car for $34, 000. She has a
down payment of $10, 000 and is nancing the remaining amount at 3.4%
compounded semi-annually over 5 year period. What payments must Rachel
make every half year?
Solution: The total amount for nancing is $34, 000 $10, 000 = $24, 000
So P = 24000, m = 2, r = 0.034, i = 0.034/2 = 0.017, n = 2 5 = 10.
Therefore, the payment
R = P
_
1 (1 + i)
n
i
_
1
= $24000
_
1 (1 + 0.017)
10
0.017
_
1
= $2630.07.
Example 10. You receive an inheritance of $100, 000 after taxes have
been deducted and immediately place into an account paying 6% per year
compounded monthly. You would like to make monthly withdrawals to
supplement your income for 20 years.
(a) What is the amount of each withdrawal?
(b) What is the total amount of interest earned over the 20-year period.
(c) After 12 years, you decide to stop making the withdrawals since you
need a down payment for house you want to purchase. What is the
value of the account of this time?
Solution: P = $100, 000, m = 12, r = 0.06, i = 0.06/12 = 0.005, t = 20, n =
mt = 12 20 = 240.
(a)
R = P
_
1 (1 + i)
n
i
_
1
= $100000
_
1 (1 + 0.005)
240
0.005
_
1
= $716.43.
(b) nR = 240 716.43 = $171943.20. Therefore
I = $(171943.20 100000) = $71943.20.
(c) R = $716.43, m = 12, r = 0.06, i = 0.005, t = 8, n = 12 8 = 96.
Then
P = R
_
1 (1 + i)
n
i
_
= $716.43
_
1 (1 + 0.005)
96
0.005
_
= $54516.90.
Amortization: When a loan and its interest charges are paid back in a
sequence of regular payments then we say that loan is Amortized. The
amortized payments is given by
R = P
_
1(1+i)
n
i
_
1
.
Example 11. Recall that in Example 9, Rachel make monthly payment
$2630.07. How much that payment goes towards the principal and interest
charged?
At rst payment:
I = Pi = $24000 0.017 = $408.
Therefore
R iP = $2630.07 $408 = $222.07.
Hence $408 is the portion of the 1st payment of $2630.07 that goes towards
the interest charges and $222.07 that goes towards the principal. The unpaid
balance remaining is
P
new
= P
old
(R P
old
i)
= $24000 (2630.07 408)
= $21777.93.
Repeat the same calculation for the 2nd payment:
I = Pi = $21777.93 0.017 = $370.22 interest
Therefore
R iP = $2630.07 $370.22 = $2259.85 principal
Hence P
new
= $21777.93 2259.85 = $19518.08.
Payment
Number
Payment
R
Interest Portion
I = i P
Portion Applied
to Principal
R I = R i P
Principal
(Unpaid Balance)
P
new
= P
old
(R i P
old
)
0 $ 24,000,00
1 $ 2630.07 $ 408.00 $ 2222.07 21,777.93
2 2630.07 370.22 2259.85 19,518.08
3 2630.07 331.81 2298.26 17,219.82
4 2630.07 292.74 2337.33 14,882.48
5 2630.07 253.00 2377.07 12,505.41
6 2630.07 212.59 2417.48 10,087.93
7 2630.07 171.49 2458.58 7629.36
8 2630.07 129.70 2500.37 5128.99
9 2630.07 87.19 2542.88 2586.11
10 2630.07 43.96 2586.11 0
Canadian Mortgage Calculation: Canadian mortgages are compounded
semi-annually but mostly the payment are made monthly. So
_
1 +
r
monthly
12
_
12
1 =
_
1 +
r
semiannually
2
_
2
1
i.e.
_
1 +
r
monthly
12
_
12
=
_
1 +
r
semiannually
2
_
2
or
r
monthly
12
=
_
1 +
r
semiannually
2
_ 2
12
1
or
r
monthly
= 12
_
_
1 +
r
semiannually
2
_1
6
1
_
.
So the monthly rate for semi-annually compounded mortgage is
r
monthly
= 12
_
_
1 +
r
semiannually
2
_1
6
1
_
.
Example 12. A family purchased a home for $240, 000 in 1995 by paying
down payment of $60, 000 and amortizing the rest with equal monthly pay-
ments over 20 years at 7.05% per year compounded semi-annually. In 2006,
the net worth of the house was $330, 000. How much equity did the family
have in house?
Solution: First the total amount for the mortgage is
$240, 000 60, 000 = $180, 000.
The monthly rate is
r
monthly
= 12
_
_
1 +
0.0705
2
_1
6
1
_
= 0.0694863.
Since m = 12, r = 0.0694863, i = 0.0694863/12 = 0.0057905, t = 20, m =
12 20 = 240. So the monthly payment is
R = $180, 000
_
1 (1.0057905)
240
0.0057905
_
1
= $1389.99.
In 2006, only 9 years left to amortize the house, the present value for the
next 9 years of R is
P = $2389.99
_
1 (1.0057905)
129
0.0057905
_
= $111, 375.82.
Therefore, in 2006, they owns $111, 375.82 to the bank and the equity is
= $330, 000 $111, 375.82 = $218, 624.90.