Understanding

Money Management part-01

Dr. Esam Alhomaidhi

Department of Systems Engineering: Industrial Engineering

FIRST SEMESTER (231)

ISE 307: Engineering Economics analysis

 Main Objectives of Ch. 03
1. To understand interest rate statements that
include nominal and effective rates.
2. To be able to determine the effective interest
rate for any stated time period.
3. To learn how to calculate effective interest
rates based on payment periods.
4. To be able to use the effective interest rate
formula for interest rates that are compounded
continuously.
5. To understand the management of a debt.
 Main Issues to Consider
1. If payments occur more frequently than annual,
how do you calculate economic equivalence?
2. If the interest period is other than annual, how do
you calculate economic equivalence?
3. How are commercial loans structured?
4. How should you manage your debt?
 Nominal Versus Effective
Interest Rates (1)
❑ Nominal Interest Rate:
Interest rate quoted based on an
annual period (Annual Percentage
Rate) APR.
Defined as a stated interest rate. Works
according to the simple interest and does
not take into account the compounding
periods.
 Nominal Versus Effective
Interest Rates (2)
❑Effective Interest Rate:
Actual interest earned or paid in a year or some other time
period (Annual Percentage Yield) APY.
➢Effective interest rate is the one which considers the
compounding periods during a payment plan.
➢It is used to compare the annual interest between loans
with different compounding periods like week, month,
year etc.
➢In general the effective interest rate is higher than the
stated or nominal one.
 Significance between APR and APY
Effective and nominal interest rates allow banks to use the number that looks most
advantageous to the consumer. When banks are charging interest, they advertise the
nominal rate, which is lower and does not reflect how much interest the consumer would
owe on the balance after a full year of compounding. On the other hand, with deposit
accounts where banks are paying interest, they generally advertise the effective rate
because it is higher than the nominal rate.

Therefore, if you were to borrow money at 8 percent APR and immediately deposit it in
an account at 8 percent APY, the deposit account will have less money at the end of the
year than you owe on the debt.

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Annual Percentage Rate (APR)
Each month the bank will
charge 1.5% interest on
18% Compounded Monthly the unpaid balance

Nominal Interest
interest rate period

Example: interest
arrangement for a credit
Annual card: “18% compounded
monthly”
percentage
rate (APR)
Annual Percentage Yield (or
Effective Interest Rate)
The Annual Percentage Yield APY (or Effective
Interest Rate APR) is the one rate that truly
represents the interest earned in a year.
On a yearly basis, you are looking for a
cumulative rate 1.5% each month for 12 times
(1.5% x 12=18%).
This cumulative rate predicts the actual payment
on your outstanding credit card balance.

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 18% Compounded Monthly
What Does It Really Mean?
◦ 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.
 Effective Annual Interest
Earned
❑ Question: Suppose that you invest $1 for 1 year at
18% compounded monthly. How much interest
would you earn?
❑ Solution: F = $1(1 + i )12 = $1(1 + 0.015)12
= $1.1956
ia = 0.1956 or 19.56%
In other words, paying 1.5% interest per month for 12 months is
equivalent to paying 19.56% interest just on time each year.
18%

1.5%
Relationship Between Nominal
and Effective Interest Rates
18%
1.5%

❑18% compounded monthly

or
❑1.5% per month for 12 months
or
❑19.56% compounded annually
Effective Annual Interest Rate
or Annual Percentage yield (APY)

ia = (1 + r / M ) M
−1
r = nominal interest rate per year
ia = effective annual interest rate
M = number of interest periods per year
◼ r/M: the interest rate per compounding period
 Effective Interest Rates with Different
Compounding Periods
More frequent compounding increases the amount of interest
paid over a year at the same nominal interest rate.
Effective Rates
Nominal
Rate Compounding Compounding Compounding Compounding Compounding
Annually Semi-annually Quarterly Monthly 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
Calculating Effective Interest Rates
Based on Payment Periods

Payment period

Interest period

Effective interest rate

per payment period

0 1 2 3 Month 0 1 2 3
 Effective Interest Rate per Payment
Period (i) with Discrete Compounding

i = [1 + r / CK ] − 1 C

❑ C = number of interest periods per payment period

❑ K = number of payment periods per year
❑ CK = total number of interest periods per year, or M
❑ r = nominal interest rate per year
Relationship between i and ia
Saving account that earns 12% interest compounded monthly:
12% compounded monthly
Payment Period = Quarter; Compounding Period = Month
K=4, C=3

1st Qtr 2nd Qtr 3rd Qtr 4th Qtr

1% 1% 1%
3.030 %

One-year
• Effective interest rate per quarter
i = (1 + 0.12 / 3 * 4) 3 − 1 = 3.030 % i = [1 + r / CK ]C − 1
• Effective annual interest rate ia = (1 + r / M ) M − 1
ia = (1 + 0.01)12 − 1 = 12.68%
ia = (1 + 0.03030 )4 − 1 = 12.68%
 Example 3.2 Page 118
Suppose you make quarterly deposits into a savings
account that earns 8% compounded monthly, compute
the effective interest rate per quarter and per year
Given r = 8%,
K = 4 payments periods per year
C = 3 interest periods per quarter
The Effective interest rate based on the payment period:
i = [1 + r / CK ]C − 1
= [1 + 0.08 / (3)( 4 )]3 − 1
= 2.013% per quarter
The Effective interest rate (per year): ia= (1 + 0.02013)4 -1 = 8.3%
Effective Interest Rate per Payment
Period with Continuous Compounding
To be competitive in the financial market, some
financial institutions offer more frequent
compounding.
As the number of compounding period (M) becomes
very large, the interest rate per compounding period
(r/M) becomes very small.
As M approaches to infinity and r/M approaches to
zero, we approximate this case to the situation of
continuous compounding.
Effective Interest Rate per Payment
Period with Continuous
Compounding

i = [1 + r / CK ] − 1 C

where CK = number of compounding periods per year

Continuous compounding means that:

C→
Effective Interest Rate per Payment
Period with Continuous Compounding
Background information: definition of e (Euler’s number)

As a limit, interest may be considered to be compounded an

infinite number of times per year – continuously

x
 1
lim 1 +  = e  2.718
x →
 x
 CK r r K
 
   
 r 
C
    r

i = lim 1 + − =
 CK →   +
1
 −  =
K
−1
 1 lim

1  1

e
CK →
 CK    CK 
  
  
 r  
Example 3.3 Calculating an
effective interest rate
Find the effective interest rate per quarter at nominal rate
8% compounded :
◦ (a) Quarterly
◦ (b) monthly
◦ (c) Weekly
◦ (d) continuously

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 Case a: 8% compounded quarterly
❑ Payment Period = Quarter
❑ Interest Period = Quarterly
1st Q

2nd Q 3rd Q 4th Q

1 interest period Given r = 8%,
K = 4 payments per year
C = 1 interest period per quarter
i = [1 + r / CK ]C − 1
= [1 + 0.08 / (1)( 4)]1 − 1
= 2.000% per quarter
 Case b: 8% compounded monthly
❑ Payment Period = Quarter
❑ Interest Period = Monthly
1st Q

2nd Q 3rd Q 4th Q

3 interest periods
Given r = 8%,
K = 4 payments per year
C = 3 interest periods per quarter
i = [1 + r / CK ]C − 1
= [1 + 0.08 / (3)( 4)]3 − 1
= 2.013% per quarter
Case c: 8% compounded weekly
❑ Payment Period = Quarter
❑ Interest Period = Weekly
1st Q

2nd Q 3rd Q 4th Q

13 interest periods
Given r = 8%,
K = 4 payments per year
C = 13 interest periods per quarter
i = [1 + r / CK ]C − 1
= [1 + 0.08 / (13)( 4)]13 − 1
= 2.0186% per quarter
Case d: 8% compounded continuously
❑ Payment Period = Quarter
❑ Interest Period = Continuously
1st Q

2nd Q 3rd Q 4th Q

 interest periods
Given r = 8%,
K = 4 payments per year
i = er / K −1
= e 0.08 / 4 − 1
= 2.0201% per quarter
 Example 3.3 Page 120
Summary: Effective Interest Rate per
Quarter
Case a Case b Case c Case d
8% 8% 8% 8%
compounded compounded compounded compounded
quarterly monthly weekly continuously
Payments Payments Payments Payments
occur quarterly occur quarterly occur quarterly occur quarterly

2.000% per 2.013% per 2.0186% per 2.0201% per

quarter quarter quarter quarter