Chapter 5

Interest Rates





1. Discuss how interest rates are quoted, and compute the
effective annual rate (EAR) on a loan or investment.
2. Apply the TVM equations by accounting for the
compounding periods per year.
3. Set up monthly amortization tables for consumer loans, and
illustrate the payment changes as the compounding or
annuity period changes.
4. Explain the real rate of interest and the impact of inflation
on nominal rates.
5. Summarize the two major premiums that differentiate
interest rates: the default premium and the maturity
premium.
6. Amaze your family and friends with your knowledge of
interest rate history.
Learning Objectives
5.1 How Financial Institutions Quote
Interest Rates: Annual and Periodic
Interest Rates
Most common rate quoted is the annual percentage rate (APR)
It is the annual rate based on interest being computed once a year.
Lenders often charge interest on a non-annual basis.
In such a case, the APR is divided by the number of compounding
periods per year (C/Y or m) to calculate the periodic interest rate.
For example: APR = 12%; m=12; i%=12%/12= 1%
The Effective Annual Rate is the true rate of return to the lender
and true cost of borrowing to the borrower.
An EAR, also known as the annual percentage yield (APY) on an
investment, is calculated from a given APR and frequency of
compounding (m) by using the following equation:

( )
1 1
|
.
|

\
|
+ =
m
m
APR
EAR
Annual and Periodic Interest Rates
(continued)
Example 1: Calculating EAR or APY
The First Common Bank has advertised one of its loan offerings as
follows:
We will lend you $100,000 for up to 3 years at an APR of 8.5%
(interest compounded monthly). If you borrow $100,000 for 1 year,
how much interest will you have paid and what is the banks APY?

Answer
Nominal annual rate = APR = 8.5%
Frequency of compounding = C/Y = m = 12
Periodic interest rate = APR/m = 8.5%/12 = 0.70833% = .0070833

APY or EAR = (1.0070833)
12
- 1 = 1.08839 - 1 =8.839%
TI BAII+ -1 [PV] 8.5 12 = 0.7083 [I/Y] 12 [N] 0 [PMT] CPT [FV]
1.0884

Total interest paid after 1 year = .08839*$100,000 = $8,839.05

Summary: Banks APY (8.84%) > Banks APR (8.5%)



5.2 Effect of Compounding Periods
on Time Value of Money Equations
TVM equations require the periodic rate
(r%) and the number of periods (n) to be
entered as inputs.
The greater the frequency of payments
made per year, the lower the total amount
paid.
More money goes to principal and less interest is
charged.
The interest rate (r, I/Y) entered should
be consistent with the frequency of
compounding and the number of
payments (n, N) involved.


5.2 Effect of Compounding Periods on
Time Value of Money Equations

Example 2: Effect of payment frequency on total
payment

Jim needs to borrow $50,000 for a business
expansion project. His bank agrees to lend him the
money over a 5-year term at an APR of 9% and will
accept either annual, quarterly, or monthly
payments with no change in the quoted APR.
Calculate the periodic payment under each alternative
and compare the total amount paid each year under
each option.



5.2 Effect of Compounding Periods on Time
Value of Money Equations (continued)
Example 2 Answer
Loan amount = $50,000
Loan period = 5 years
APR = 9%
Annual payments: PV = -50000; n=5; i = 9; FV=0; P/Y=1;C/Y=1; CPT
PMT = $12,854.62

Quarterly payments: PV = 50000; n=20; i = 9; FV=0;
P/Y=4 (TI-BAII+: [2
nd
] [I/Y] Displays P/Y [4] [Enter];
C/Y=4 (TI-BAII+: [2
nd
] [I/Y] [] Display C/Y [4] [Enter];

Or Leave [P/Y], [C/Y] alone, and simply change APR: 9/4 = 2.25 [I/Y]
-50000 [PV] 5 x 4 = 20 [N] 0 [FV] [CPT] [PMT] $3132.10

Total annual payment = $3132.1*4 = $12,528.41

Monthly payments: 912 = 0.74 [I/Y]
-50000 [PV] 5x12 = 60 [N] 0 [FV] [CPT] [PMT] = $1037.92

Total annual payment = $1037.92*12 = $12,455.04
5.2 Effect of Compounding Periods on
Time Value of Money Equations
Example 3: Comparing annual and monthly
deposits.

Joshua, who is currently 25 years old, wants to invest
money into a retirement fund so as to have
$2,000,000 saved up when he retires at age 65. If
he can earn 12% per year in an equity fund,
calculate the amount of money he would have to
invest in equal annual amounts and alternatively,
in equal monthly amounts starting at the end of
the current year or month respectively.

5.2 Effect of Compounding Periods on Time
Value of Money Equations
(Example 3Answer)
With annual deposits: With monthly deposits:
(Using the APR as the interest rate)
FV = -$2,000,000; FV = -$2,000,000;
N = 40; N = 12*40=480;
I/Y = APR = 12%; I/Y = APR/12
= 12 12 = 1%;
PV = 0; PV = 0;
C/Y=1; C/Y = 12
P/Y=1; P/Y = 12
CPT PMT = $2,607.25 CPT PMT = $169.99
Total annual = 169.99 x 12
= 2039.88



Interest is charged only on the outstanding
balance of a typical consumer loan.

Increases in frequency and size of
payments result in reduced interest charges
and quicker payoff due to more being applied
to loan balance.

Amortization schedules help in planning
and analysis of consumer loans.

5.3 Consumer Loans and
Amortization Schedules



5.3 Consumer Loans and
Amortization Schedules (continued)



Example 4: Paying off a loan early!

Kay has just taken out a $200,000, 30-year, 5%,
mortgage. She has heard from friends that if she
increases the size of her monthly payment by one-
twelfth of the monthly payment, she will be able to
pay off the loan much earlier and save a bundle on
interest costs. She is not convinced.
Use the necessary calculations to help convince her
that this is in fact true.

5.3 Consumer Loans and
Amortization Schedules (continued)

Example 4 Answer
We first solve for the required minimum monthly payment:
PV = $200,000; I/Y=5; N=30*12=360; FV=0; C/Y=12; P/Y=12; PMT
= ? $1073.64
[SIMPLE] 512 = 0.4167 [I/Y] 30*12=360 [N] 0
[FV] -200000 [PV] CPT [PMT] 1073.64

Next, we calculate the number of payments required to pay off
the loan, if the monthly payment is increased by
1/12*$1073.64 i.e. by $89.47
PMT = 1163.11 (= 1073.64 + 89.47); PV=$200,000; FV=0; I/Y=5;
C/Y=12; P/Y=12; N = ? N= 303.13 months or 303.13/12 = 25.26
years.
[SIMPLE] 512 = 0.4167 [I/Y] 1163 [PMT] -
200000 [PV] 0 [FV] CPT [N] 303.13

5.3 Consumer Loans and Amortization
Schedules (continued)

Example 4 (Answer) (continued)

With minimum monthly payments:
Total paid = 360*$1073.64 = $386, 510.4
Amount borrowed = $200,000.0
Total interest paid = $186,510.4

With higher monthly payments:
Total paid = 303.13*$1163.11 = $353,573.53
Amount borrowed = $200,000.00
Total interest paid = $153,573.53

Interest saved = $186,510.4 - $153,573.53
= $32,936.87

5.4 Nominal and Real Interest
Rates
The nominal risk-free rate is the rate of interest earned
on a risk-free investment such as a bank CD or a
treasury security.
It is essentially a compensation paid for the giving up of
current consumption by the investor
The real rate of interest adjusts for the erosion of
purchasing power caused by inflation.
The Fisher Effect shown below is the equation that
shows the relationship between the real rate (r*), the
inflation rate (h), and the nominal interest rate (r):
(1 + r) = (1 + r*) x (1 + h)
r = (1 + r*) x (1 + h) 1
r = r* + h + (r* x h)

5.4 Nominal and Real Interest
Rates (continued)
Example 5: Calculating nominal and real
interest rates
Jill has $100 and is tempted to buy 10
t-shirts, with each one costing $10. However,
she realizes that if she saves the money in a
bank account she should be able to buy 11 t-
shirts. If the cost of the t-shirt increases by
the rate of inflation, i.e. 4%, how much would
her nominal and real rates of return have to
be?

5.4 Nominal and Real Interest
Rates (continued)
Example 5 (Answer) (continued)
Real rate of return = (FV/PV)
1/n
-1
= (11shirts/10shirts)
1/1
-1
= 10%
Price of t-shirt next year = $10(1.04) = $10.40
Total cost of 11 t-shirts = $10.40*11 = $114.40 = FV
PV = $100; n=1; I/Y = (FV/PV) -1 = (114.4/100)-1
= 14.4%
Nominal rate of return = 14.4%
= Real rate + Inflation rate + (real rate*inflation rate)
= 10% + 4% + (10%*4%) = 14.4%

5.5 Risk-Free Rate and
Premiums
The nominal risk-free rate of interest such as the rate of
return on a treasury bill includes the real rate of interest
and the inflation premium.
The rate of return on all other riskier investments
(r) would have to include a default risk premium (dp)and a
maturity risk premium (mp), i.e.
r = r
*

+

inf + dp + mp.
30-year corporate bond yield > 30-year Treasury bond
yield
Due to the increased length of time and the higher default risk
on the corporate bond investment.


5.6 A Brief History of Interest Rates
and Inflation in the United States

Figure 5.4 Inflation rates in the United
States, 19501999.
5.6 A Brief History of Interest Rates
and Inflation in the United States
(continued)
Figure 5.5 Interest rates for the three-
month treasury bill, 19501999.
5.6 A Brief History of Interest Rates
and Inflation in the United States
(continued)
Table 5.5 Yields on Treasury Bills, Treasury
Bonds, and AAA Corporate Bonds, 19501999
5.6 A Brief History of Interest Rates
and Inflation in the United States
(continued)
A fifty year analysis (1950-1999) of the historical
distribution of interest rates on various types of
investments in the USA shows:
Inflation at 4.05%,
Real rate at 1.18%,
Default premium of 0.53% (for AAA-rated over
government bonds) and,
Maturity premium at 1.28% (for twenty-year
maturity differences).

Additional Problems with Answers
Problem 1
Calculating APY or EAR. The First Federal
Bank has advertised one of its loan
offerings as follows:
We will lend you $100,000 for up to 5 years at
an APR of 9.5% (interest compounded
monthly.)
If you borrow $100,000 for 1 year and
pay it off in one lump sum at the end of
the year, how much interest will you
have paid and what is the banks APY?


Additional Problems with Answers
Problem 1 (Answer)
Nominal annual rate = APR = 9.5%
Frequency of compounding = C/Y = m = 12
Periodic interest rate = APR/m = 9.5%/12 = 0.79167%
= .0079167




APY or EAR = (1.0079167)
12
- 1 = 1.099247 - 1 9.92%
Payment at the end of the year = 1.099247*100,000
$109,924.70

Amount of interest paid = $109, 924.7 - $100,000
$9,924.7
( )
1
m
APR
1 EAR
m

|
.
|

\
|
+ =
Additional Problems with Answers
Problem 2
EAR with monthly compounding
If First Federal offers to structure the 9.5%,
$100,000, 1 year loan on a monthly
payment basis, calculate your monthly
payment and the amount of interest paid at
the end of the year. What is your EAR?

Additional Problems with Answers
Problem 2 (Answer)







N i/y PV PMT FV
12 9.5/12 100,000 -8,768.35 0

Calculate monthly payment:
Total interest paid after 1 year
= 12*$8,768.35 - $100,000
= $105,220.20 - $100,000
= $5,220.20

EAR is still 9.92%, since the APR and m are the
same as #1 above,

APY or EAR = (1.0079167)
12
- 1 = 1.099247 - 1
=9.92%



Additional Problems with Answers
Problem 3
Monthly versus quarterly payments:
Patrick needs to borrow $70,000 to start a
business expansion project. His bank
agrees to lend him the money over a 5-year
term at an APR of 9.25% and will accept
either monthly or quarterly payments with
no change in the quoted APR.
Calculate the periodic payment under each
alternative and compare the total amount
paid each year under each option.
Which payment term should Patrick accept
and why?



Additional Problems with Answers
Problem 3 (Answer)

Calculate monthly payment:
n=60; i/y = 9.25%/12; PV = 70000; FV=0;
PMT=1,461.59

Calculate quarterly payment:
n=20; i/y = 9.25%/4; PV = 70000; FV=0; PMT=4,411.15

Total amount paid per year under each payment type:
With monthly payments = 12* $1,461.59 = $17,539.08
With quarterly payments = 4*$4,411.15 = $17,644.60

Additional Problems with Answers
Problem 3 (Answer) (continued)
Total interest paid under monthly compounding
Total paid - Amount borrowed
= 60*$1,461.59 - $70,000
= $87,695.4 - $70,000
= $17,695.4

Total interest paid under quarterly compounding
20 *$4,411.15 -$70,000
= $88,223 - $70,000
= $18,223
Since less interest is paid over the 5 years with the
monthly payment terms, Patrick should accept
monthly rather than quarterly payment terms.


Additional Problems with Answers
Problem 4
Computing payment for early payoff:
You have just taken on a 30-year, 6%,
$300,000 mortgage and would like to pay it
off in 20 years. By how much will your
monthly payment have to change to
accomplish this objective?
Additional Problems with Answers
Problem 4 (Answer)
Calculate the current monthly payment under the 30-year,
6% terms:
n=360; i/y = 6%/12; PV = 300000; FV=0;
CPT PMT1,798.65
Next, calculate the payment required to pay off the loan in
15 years or 180 payments
n=180; i/y = 6%/12; PV = 300000; FV=0;
CPT PMT2,531.57
The increase in monthly payment required to pay off the loan in
20 years = $2,531.57 - $1,798.65 = $732.92


Additional Problems with Answers
Problem 5
You just turned 30 and decide that you
would like to save up enough money so as
to be able to withdraw $75,000 per year for
20 years after you retire at age 65, with the
first withdrawal starting on your 66
th

birthday. How much money will you have to
deposit each month into an account earning
8% per year (interest compounded
monthly), starting one month from today, to
accomplish this goal?



Additional Problems with Answers
Problem 5 (Answer)
Calculate the amount of money needed to be
accumulated at age 65 to provide an annuity of
$75,000 for 20 years with the account earning 8%
per year (interest compounded monthly)
n=20; i/y = 8%; FV=0; PMT=75,000; P/Y = 1; C/Y=12
CPT PV720,210.86
Next, calculate the monthly deposit necessary to
accumulate a FV of $720,210.86 over 35 years or
12*35 = 420 months:
n=420; i/y = 8%; FV=720,210.86; P/Y = 12; C/Y=12
CPT PMT313.97


Table 5.1 Periodic Interest Rates
Table 5.2 $500 CD with 5% APR,
Compounded Quarterly at 1.25%
TABLE 5.3 Abbreviated Monthly
Amortization Schedule for $25,000 Loan, Six
Years at 8% Annual Percentage Rate
TABLE 5.4 Advertised Borrowing and
Investing Rates at a Credit Union, January
22, 2012
Table 5.6 Yields on Treasury Bills,
Treasury Bonds, and AAA Corporate
Bonds, 20002010
FIGURE 5.1 Interest rate
dimensions.
Figure 5.2 Upward-sloping yield
curve.
Figure 5.3 Downward-sloping
yield curve.