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    Lecture 5 - Effective Interest

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    asandasap1

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    © All Rights Reserved
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    Lecture 5 - Effective Interest

    Uploaded by

    asandasap1
    2 views8 pages

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    2 views8 pages

    Lecture 5 - Effective Interest

    Uploaded by

    asandasap1

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    of 8

    MAMI OLOF

    Lecture 5118102
    effective interest

    note please watch the lecture video


    for Lesson 5 that Dr Uys uploaded
    in the Lesson tab on Vala

    Lecturer James Mbewa


    Last time in MAMI Olof
    Annuity Formula
    D pmtft g.fi
    gj

    TImt
    gives you present value D of a series of
    payments PMT
    common example imy a loan of value D payed off
    with payments
    Comparison with Sinking fund formula
    Annuity formulaa gives the present value at the
    beginning of series of payments
    Sinking Fund formula gives the future value at the
    end of a series of payments
    Examples
    Annuity Formula Equation of Value Sinking fund
    Effective Rate of Interest
    Definition
    The effective rate of interest re is the
    rate of interest compounded annually
    that has the same effect as the nominal
    ie stated or named interest rate
    e.g r compounded monthly
    Example 1
    Peter has borrowed R5000 from his bank. Bank charges
    Peter interest at the rate 12.5% per annum compounded
    monthly. What is the effective interest rate being charged
    by the bank?

    lyear
    Pv 5000 re IX EV 5000 Iti

    With interest rate 12 0 pa compounded monthly


    Fu would be
    FV PV Iti I YEE 12
    1 n 12 1
    FV 5000 1 42
    R 5662.08
    With interest rate re compounded annually FV
    would be
    Fv Prati i next re
    FV 5000 i t re no 1 1 1

    If the effect of both interest rates is the same then


    the Fus should be equal
    set
    50001 re 50004 55 7

    Pvs cancel so re
    I re at
    0 132416
    I

    re
    does not depend
    on amount of
    13.249g
    the loan

    Note You advised not to memorise


    are the formula in the
    textbook as it is not best to use for all examples
    such as Example 2
    Example 2
    Bank A charges interest at the rate 14% per annum
    compounded monthly. Bank B charges 13% compounded
    daily. Which bank offers the better deal?

    You could calculate the effective interest rate for both


    banks and compare them That's two calculations Or
    you could just calculate the equivalent monthly rate re
    charged by Bank B and compare that with Bank A

    Banks
    y
    i year
    PV FV Pv Iti

    For Bank B the future value FV of the amount PV


    after one year at 13 0
    compounded daily
    Fv Pv Iti
    30
    i fo
    n osx
    pv it g
    ForBank A the future value FV of the amount PV
    one year at the equivalent interest rate re
    after
    compounded monthly is
    FV PV Sti i ret1 12
    n 12
    Pv l
    E
    If the interest rates are equivalent then the future values
    must be the same we must accumulate the same
    amount of interest
    set 0
    take the
    12th root on
    bothsides to 1
    cancel the 12th
    I
    E 010890277
    power re 0 13068 13.07 6 14
    nafta
    ft notation any
    OR a

    Bank B offers a better deal Its equivalent monthly rate


    is less than the monthly rate changed by Bank A
    Example 3
    You have $5,000 to invest at 6% annual interest
    compounded monthly. How long will it take for your
    investment to grow to $6,000?
    Note this question is nothing to do with effective
    interest but important

    prison
    months

    The only unknown is n the number of months


    Fu pv ti i if 0.005
    6000 8000 it 0.005
    1.2 1 Oo s
    1.005 an
    dog 1 2 n log log n
    logo
    8171
    n
    36.6 months
    Since interest is added at the end of the month you will
    have to wait 37 months

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