ECON320_3_UnderstandingMoneyManagement

ECON320_3_UnderstandingMoneyManagement - Chapter 3...

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1 Chapter 3 Understanding Money Management Nominal and Effective Interest Rates Equivalence Calculations using Effective Interest Rates Debt Management

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2 Nominal and Effective  Interest Rates Lecture No. 8 Professor C. S. Park Fundamentals of Engineering Economics Copyright © 2005
3 Focus 1. If payments occur more frequently than annual, how do you calculate economic equivalence? 1. If interest period is other than annual, how do you calculate economic equivalence? 2. How are commercial loans structured? 3. How should you manage your debt ?

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4 Nominal Versus Effective Interest Rates Nominal Interest Rate : Interest rate quoted based on an annual period Effective Interest Rate : Actual interest earned or paid in a year or some other time period
5 18%  Compounded  Monthly Nominal interest rate Annual percentage rate (APR) Interest period

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6 18%  Compounded  Monthly What It Really Means ? Interest rate per month ( i ) = 18%/12 = 1.5% Number of interest periods per year ( N ) = 12 In words , Bank will charge 1.5% interest each month on your unpaid balance, if you borrowed money You will earn 1.5% interest each month on your remaining balance, if you deposited money
7 18% compounded monthly Example 1 : Suppose that you invest \$1 for 1 year at 18% compounded monthly. How much interest would you earn? = 1.5% 18%

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8 : 1.5% 18% 18% compounded monthly or 1.5% per month for 12 months = 19.56 % compounded annually
9 Effective Annual Interest Rate  (Yield) r = nominal interest rate per year 1 ) / 1 ( - + = M a M r i

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10 Example 2 If your credit card calculates the interest based on 12.5% APR, what is your monthly interest rate and annual effective interest rate, respectively? Your current outstanding balance is \$2,000 and skips payments for 2 months. What would be the total balance 2 months from now?
11 Example 3 Suppose your savings account pays 9% interest compounded quarterly . If you deposit \$10,000 for one year, how much would you have?

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12 Nominal and Effective Interest Rates with  Different Compounding Periods Effective Rates Nominal Rate Compounding Annually Compounding Semi-annually Compounding Quarterly Compounding Monthly Compounding Daily 4% 4.00% 4.04% 4.06% 4.07% 4.08% 5 5.00 5.06 5.09 5.12 5.13 6 6.00 6.09 6.14 6.17 6.18 7 7.00 7.12 7.19 7.23 7.25 8 8.00 8.16 8.24 8.30 8.33 9 9.00 9.20 9.31 9.38 9.42 10 10.00 10.25 10.38 10.47 10.52 11 11.00 11.30 11.46 11.57 11.62 12 12.00 12.36 12.55 12.68 12.74
Effective Annual Interest Rates  (9% compounded quarterly) First quarter Base amount + Interest (2.25%) \$10,000 + \$225 Second quarter = New base amount + Interest (2.25%) = \$10,225 +\$230.06 Third quarter = New base amount + Interest (2.25%) = \$10,455.06 +\$235.24 Fourth quarter

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ECON320_3_UnderstandingMoneyManagement - Chapter 3...

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