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The following variables are used for all of the financial formulas:
P = Principal, or starting, amount of money if a single amount is deposited and gaining
interest or a single amount is borrowed in a loan.
R = Regular Payment / Withdrawal amount
r = annual interest rate, or APR (changed to a decimal)
n = number of times interest is compounded per year. Note that if withdrawals or
payments are made regularly they also be made at the same time interval.
rc = nr = an abbreviation since this fraction shows up a lot.
N = n·t = an abbreviation. Also represents the total number of payments or withdrawals
that are made.
S = Will be different for each formula. It is usually the account balance after some
amount of time.
2 Simple Interest
Simple interest is calculated from a single amount of money placed in an account and gaining
interest over time without additional amounts being added. Simple interest is distinguished
from compound interest in that interest is ALWAYS calculated from the principal, not from
the current updated amount in the account.
Formula:
S = P (1 + rt)
Here S is the account balance after t years.
3 Compound Interest
Compound interest is calculated from a single amount of money placed in an account and
gaining interest over time without additional amounts being added. Compound interest is
distinguished from simple interest in that interest for a period is calculated from the account
balance at the beginning of that period, NOT the principal. This means that interest earned
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in one period gains interest on itself in future periods.
Formula:
S = P (1 + rc )N
Here S is the account balance after t years.
Formula:
S = P ert
Here S is the account balance after t years. Note that e is the special constant that is
roughly 2.718. Use your calculator’s e button to compute with it.
5 APY
This term stands for Annual Percentage Yield and refers to the percentage by which an
account grows in 1 year. When you perform the calculations below you should convert the
final answer to a percent.
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To tell when to use the APY formula:
- The problem will specifically use the term APY or Annual Percentage Yield.
- The APY is the percent by which the account increases each year.
- Use the guidelines above to decide which APY formula to use.
AP Y = (1 + rc )n − 1
Formula (Continuous Compounding):
AP Y = er − 1
Note that simple interest does not have an APY since its growth is linear, not exponential.
The APY only applies to an account which grows exponentially. If a problem does happen
to want the APY of a simple interest account, use the regular compounding formula with
n = 1.
Formula:
(1 + rc )N − 1
S = R( )
rc
Here S is your account balance after t years of regular deposits.
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to this situation as a ”Savings Plan” since you have some money you can put aside, usually
every month, to gain some interest. It is an Annuity Due if you make the deposits at the
beginning of each period, so each deposit makes interest the same month you put it in.
Formula:
(1 + rc )N − 1
S = R(1 + rc )( )
rc
Here S is your account balance after t years of regular deposits. Note that this is the
same as the Ordinary Annuity formula but with an extra (1 + rc ) term.
8 Sinking Fund
This consists of an account into which you put regular amounts of money over a long period
of time. Then at these regular intervals the current balance gains interest. This formula is
distinguished from the above two situations in that this time you know how much money
you want to have at the end - the unknown is how much you need to add each month.
Formula:
rc
R = S( )
(1 + rc )N − 1
Here S is the account balance you’d like to have after t years of regular deposits. Notice
that the formula is just the Ordinary Annuity formula solved for R instead of S.
You can also do a Sinking Fund associated to an Annuity Due (payments at the beginning
of each month) by just solving that formula for R in the same manner.
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9 Present Value of an Annuity
I like to call this one a ”Retirement Fund”. The idea is to have a large amount of money in
an interest-bearing account and make regular withdrawals until the account is empty. The
Present Value is the amount of money you need in the account at the beginning to make the
size of withdrawals you want for the next t years.
1 − (1 + rc )−N
P = R( )
rc
Formula (Annuity Due):
1 − (1 + rc )−N
P = R(1 + rc )( )
rc
We use P here because it represents a Principal or starting amount in the account before
withdrawals. Notice that again the only difference between formulas is the extra (1 + rc )
term. Also sometimes the question will give you your starting account balance (P ) and ask
how much you can withdraw each period (R). Just solve the equation for R in this case.
10 Loan Amortization
This is a situation where you have borrowed money and want to pay off the loan over time.
You pay equal payments at regular time intervals. The remainder of the loan balance is
gaining interest (which means you’ll have to pay more to pay it off).
Formula:
rc
R = P( )
1 − (1 + rc )−N
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Here P is the loan principal and R is the payment per pay period. Note that this formula
is just the Present Value of an Ordinary Annuity formula solved for R. Thus this formula
should only be used if each payment is made at the end of each pay period. To get a loan
formula for payment at the beginning of each pay period, solve for R in the Present Value of
an Annuity Due formula. If the problem does not specify, use the Ordinary Annuity forula.
Formula:
1 − (1 + rc )−N +k
PN −k = R( )
rc
Here PN −k is the Loan Payoff Amount, how much total will be paid after the first k
payments have already been made.
Note that this formula is just the Present Value of an Ordinary Annuity with N − k
substituted for N .
Practice Problems
Here are some problems to look at that will require the financial formulas. Since the em-
phasis of this sheet is on which formula to use, that is my primary concern with these. At
the end I will give solutions for which formula is the one you wanted for that problem. If
you want to know the actual numeric answers then you should just solve problems from the
book and look up your answers.
Questions
1. Gene is going to college in 5 years and is going to need $50, 000 in order to pay for
it. She decides to open an account with 4% interest compounded monthly and make
payments at the end of each month to achieve her goal. How much much will the
payments be?
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2. David had some extra money he was not using and decided to buy a U.S. Treasury
Bond. The bond he is interested in will pay 6% interest compounded twice a year for
the next 30 years. If David buys a bond worth $8, 000 now, how much will the bond
be worth in 30 years?
3. Douglas has a credit card on which he owes $400. However, he cannot afford any
payments on it right now so the balance will gain interest at an annual rate of 19.8%
compounded continuously. How much will Douglas’s credit card balance be after 1
year without paying?
4. Mickey has been planning for a long time but now he can retire. He has built up
$750, 000 in an account with an interest rate of 2.5% compounded monthly. If he
wants to live off of this account for the next 25 years, how much can he withdraw from
the account at the beginning of each month?
5. DJ just bought a new car. The car cost $18, 000, but he only had $10, 000 to use as a
down payment. The rest of cost is put in a loan with a 5.9% interest rate. If DJ wants
to pay off the loan over 5 years with monthly payments, what will his payments be?
6. Chelsea is getting married and wants to have the biggest, best marriage the world has
ever seen. As such, she plans to take out a loan in an account with a 4.5% interest rate
compounded monthly. She wants to pay the loan off in 3 years, and estimates that the
most she can possibly afford to pay each month towards the loan is $1600. What is
the biggest loan Chelsea can afford to take out for her marriage?
7. Jeff has decided to begin investing in the stock market. He begins with $10, 000 and
thinks that he can increase the size of his investment by 14% each year if he does
it correctly. How much money should he have 10 years from now if his estimate is
correct?
8. Wanda would like to retire 25 years from now and will need to have $400, 000 to retire
comfortably. To achieve this financial goal she will make a deposit every quarter to an
account with a 5.6% annual interest rate. How much must each deposit be?
9. Cleo has an investment option through her company that allows her to put $1, 000 in
an account gaining 4% simple interest for the next 12 years. How much will her money
be worth after the 12 years if she takes the offer?
10. Paul decides to put some money in an account today to pay for a world cruise 3 years
from now. The account he is interested in pays 3.4% compounded monthly. How much
should he place in the account today so it will be worth $4500 in 3 years?
11. Jared has just received a large amount of money, $15000, as a graduation present.
Since he took Math 1090, he realized the best way to spend the money is gradually
over time while the rest is gaining interest. He puts the money in an account making
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7% interest and decides to make regular withdrawals at the end of each month. How
much is he able to withdraw each month?
12. If Penny puts $4, 000 in an account with a 9% interest rate compounded continuously,
what percentage will Penny’s account actually increase by per year?
13. Chad is a fad young lad who is 12 years old, and puts the $40 his parents give him
at the beginning of each month into an account making 3.9% interest compounded
monthly. What will his account be worth by the time he turns 18?
Solutions
4. Formula 9 (Present Value of Annuity Due) - Note that R is the variable being solved
for here.
7. Formula 3 (Compound Interest) - This formula is used since the investment increases
by the same percent each year.
8. Formula 8 (Sinking Fund) - Don’t be thrown off by the word ”retire” - Wanda is making
payments over time in this problem, not making withdrawals, so this is not Formula 9.
10. Formula 3 (Compound Interest) - You will be solving for P in this formula.
11. Formula 9 (Present Value of Ordinary Annuity) - Again it is R that you need to solve
for.