16 2.

WEEK 2

Math 366 Winter 2021 Week 2 Assignment Solution

E XERCISE 2.1. Explain briefly the following terms.

(1) effective interest rate;
(2) present value;
(3) annuity;
(4) mortgage;
(5) discount factor;
(6) forward interest rate.

S OLUTION . (1) The interest after taking the effect of the number of com-
pounding into consideration; (2) the current worth of a future or past cash
amount after taking the interest rate into consideration; (3) a contract that
pays the holder a fixed amount in the future at regular time intervals; (4)
a loan backed up by some property and to be paid back in the future; (5)
a number to be multiplied by a future cash amount in order to obtain its
present value; (6) an interest rate to be charged for a loan in the future.
E XERCISE 2.2. This problem has tow parts.
(1) Define the base number e of the natural logarithm. (2) Explain why
this number is important in interest calculations.

S OLUTION . (1) e is the unique number such that

Z e
dt
= 1,
1 t
or it is the limit  t
1
lim 1+ .
t→∞ t
It is also the sum of the series
∞
1
e= ∑ .
n=0 n!
(2) If the interest rate is r per unit time and is compounded n times
evenly up to time T, then the balance of a savings account bearing that
interest rate is
rT n
 
ST,n = S0 1 + .
n
Its limit as the frequency of compounding tends to infinity is
ST = S0 erT .

E XERCISE 2.3. Suppose that the nominal interest rate is 15% per year.
What are the effective interest rates if the interest is compounded
(1) twice a year;
(2) quarterly;
 3. WEEK 2 ASSIGNMENT SOLUTION 17

(3) monthly;
(4) daily
(5) infinitely often?

S OLUTION . The effective interest rate are as follows:

 2
0.15
reff,2 = 1+ − 1 = 15.5625%,
2
 4
0.15
reff,4 = 1+ − 1 = 15.8650%,
4
 12
0.15
reff,12 = 1+ − 1 = 16.0755%,
12
 365
0.15
reff,365 = 1+ − 1 = 16.1798%,
365
reff,∞ = e0.15 − 1 = 16.1834%.

E XERCISE 2.4. Suppose that a savings account carries the interest rate
of 5% and the interest if compounded monthly. If $200 is deposited into the
account on the first day of each month beginning on January 1st. What is
the balance of the account at the end of the year?

S OLUTION . Taking the end of the year N = 12 as the present time, we

compute the total current value of all the payments. There are N = 12
payments in total. The growth factor (the reciprocal of the discount factor)
for one period is (1 + r ), where r = 0.05/12. Hence the total current value
is
N
(1 + r ) N +1 − (1 + r )
B= ∑ P · (1 + r ) n = P ·
r
.
n =1

The numerical value is B = $2, 466.00.

E XERCISE 2.5. A 30-year home loan has the initial balance of $600,000
and the interest rate 5%.
(1) What is the monthly payment of this loan?
(2) How long does it take to pay off the loan if we make an extra $200
payment every month?
(3) What is the amount of the last payment if the loan is to be paid off
at the end of the second year?
(4) Answer the above questions (1) and (3) if the loan is an interest-only
loan, meaning that each monthly payment is equal to the interest accrued
during the previous month.
18 2. WEEK 2

S OLUTION . (1) The interest rate is r = 0.05/12. The number of pay-

ments is N = 12 × 30 = 360. The loan amount is L = 600000. The total
present value of the payments is
N
P h i
L=P ∑ (1 + r ) − n = r
· 1 − (1 + r ) − N .
n =1

Hence,
Lr
P= .
1 − (1 + r ) − N
The numerical value is
0.05 1
P = 600000 · · = $3597.30.
12 1 − (1 + 0.05/12)−360
(2) Let E = 200. The new monthly payment will be P1 = P + E. The
total present value L1 for N1 payments will be
P1 h i
L1 = 1 − (1 + r )− N1 .
r
This should be greater or equal to the loan amount, i.e., we need find the
smallest integer such that
P1 h i
1 − (1 + r )− N1 ≥ L.
r
We have L = 600000, P1 = 3797.30, r = 0.06/12, and find that N1 ≥
312.94. Therefore the loan can be paid off approximately 4 years ahead of
schedule.
(3) The running balance immediately after the lth payment by the for-
mula
Ph i
Ll = 1 − (1 + r )−( N −l ) .
r
Using the formula for the equal payment
Lr
P=
1 − (1 + r ) − N
we obtain
(1 + r ) N − (1 + r ) l
Ll = L · .
(1 + r ) N − 1
We have L = 600000, r = 0.06/12, l = 24. Hence the balance immedi-
ately after the 24th payment is
L24 = 584809.41.
The the loan is to be paid off at this time, the last payment should be
584809.41 + 3597.30 = $588, 406.71.
 3. WEEK 2 ASSIGNMENT SOLUTION 19

(4) Question (1*). Since only the accrued interest is paid, the principal
balance after each payment stays the same, namely, L = 600000. The inter-
est for each month is therefore
0.06
600000 · = $3, 000.
12
Question (3*). The payoff amount is
600000 + 3000 = $603, 000.

E XERCISE 2.6. John has a credit card with a balance of $2,500 at the
interest rate 19.99% compounded daily. The minimum monthly payment
is 3% of the balance or $10, whichever is larger. Suppose that John only
makes the minimum payment each month. How long does it take John to
pay off this credit card debt?

S OLUTION . Let r be the monthly interest rate. Let Ll be the running

balance immediately after the lth payment. Then the balance immediately
before the payment is Ll −1 (1 + r ). The payment is Pl = ηLl −1 (1 + r ), where
η is the payment percentage of the balance. Hence
Ll = Ll −1 (1 + r ) − ηLl −1 (1 + r ) = (1 − η )(1 + r ) Ll −1 .
The initial balance is L0 = L. Hence
l
Ll = [(1 − η )(1 + r )] L.
We have L = 2500, η = 0.03, and the monthly effective interest rate is

0.1999 365/12
 
r = 1+ − 1 = 0.0167932205....
365
Hence
Ll = 2500 · (0.9862894239...)l .
The lth payment is equal to

Pl = ηLl −1 (1 + r ) = 0.03 · 2500 · (1.0167932205....) · (0.9862894239...)l −1 .

This payment will be in effect until it falls below 10. Solve the equation

10 = 0.03 · 2500 · (1.0167932205....) · (0.9862894239...)l −1 ,

we obtain l = 148.15631. This means that P148 is the last payment greater
than $10. In fact P148 = $10.02. Starting from 149th payment, the monthly
payment will be $10. The balance just after 148th payment is

L148 = 2500 · (0.9862894239...)148 = $324.03.

20 2. WEEK 2

Now we have a new loan with initial amount $324.03 with interest rate
19.99% and monthly payment $10. Suppose it takes N months to pay it off,
then "  N #
P 1
L= 1− .
r 1+r
We have L = 324.03, P = 10, and r = 0.0167932205.... (monthly effective
interest rate as before). This gives N = 47.172. That means that it needs 48
payments to pay off the remaining balance.
The total number of payments is equal to 148+48 = 196. This means that
it takes 16 years and 4 months to pay off the credit card debt.

E XERCISE 2.7. Perpetual annuity is a contract to pay a fixed sum peri-

odically forever. Assume that the interest rate is r per year.
(1) Find a formula for the price P of the perpetual annuity that pays C
per month?
(2) Compute P when r = 6% and C = $2, 500.

S OLUTION . (1) If the payment is C. Then the value of the annuity im-
mediately before the first payment is
∞
1+r
P = C + C (1 + r ) −1 + C (1 + r ) −2 + · · · = C ∑ (1 + r ) − n = C · r
.
n =0
Note that the value of the annuity at the time of one period before the first
payment is
1+r C
C· · (1 + r ) −1 = .
r r
(2) We have
1.005
P = 2500 · = $502, 500
0.005
immediately before the first payment.

E XERCISE 2.8. A 30 year home loan with the interest rate 4.125% has
the initial amount $675,000.
(1) What is the monthly payment P?
(2) If the homeowner chooses to pay P/2 every two weeks, how long
does it take him to pay off the loan?

S OLUTION . (1) We have r = 0.04125/12, L = 675, 000, and N = 360.

Hence the monthly payment is
Lr
P= = $3, 271.39.
1 − (1 + r ) − N
(2) Assume we make N biweekly payments. Then total present value
of all payments is
Ph i
L= 1 − (1 + r ) − N ,
r
 3. WEEK 2 ASSIGNMENT SOLUTION 21

which should be equal to the loan amount. We have P = 3271.39/2 and

L = 675000. For the interest rate, we have 365/7 weeks in a year, hence the
14
14-day interest is r = 0.04125 · 365 . We need to solve for N from the above
equation. We have
Lr
(1 + r ) − N = 1 − ,
P
hence
log(1 − Lr/P)
N=− .
log(1 + r )
The answer is N = 669.35, i.e., about 670 biweekly payments. The number
of years is
669.35 · 14
= 25.67.
365
This means that the loan will be paid off in approximately 25 years and 8
months. Therefore, by switching to biweekly payment, you can payoff the
loan more than 4 years ahead of time. Does this result surprise you?
R EMARK 2.9. This computation has not taken into consideration the fol-
lowing factors when you deal with a real home loan: (1) The loan company
still compound your interest monthly; (2) all of your payments during a
month won’t be credited to your account until the end of the month. Factor
(1) shortens your loan, whereas factor (2) lengthens it, both only slightly.