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4.1) Nominal and effective interest rates

4.2) Equivalence calculations with effective
interest rates
4.3) Equivalence calculations with continuous
payments
4.4) Changing interest rates
4.5) Debt management
4.6) Investing in financial assets

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4.1) Nominal and effective interest
rates

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Figure 4.1 The nominal interest rate is determined by summing the individual interest rates per period.

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 Example
Suppose that deposit 10.000 TL in a savings account that
pays you at an interest rate of 9% compounded quarterly.

a) The nominal interest rate is: r = ___________

b) The effective interest rate per quarter is: iq = ______

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Figure 4.3 Functional relationships among r, i, and ia, where interest is calculated based on 9% compounded monthly
and payments occur quarterly (Example 4.2).

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Example 4.3

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4.2) Equivalence calculations with
effective interest rates

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Example 4.5

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Figure 4.5 Quarterly deposits with monthly compounding (Example 4.5).

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Example 4.7

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Figure 4.7 Calculation of equivalent monthly interest when the quarterly interest rate is specified (Example 4.7).

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Figure 4.8 Cash flow diagram (Example 4.7).

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Example 4.8

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Figure 4.9 Transformed cash flow diagram created by summing monthly cash flows to the end of the quarterly
compounding period (Example 4.8).

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4.4) Changing interest rates

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 4.5) Debt management

4.5.1) Commercial loans

4.5.2) Lease financing
4.5.3) Home mortgage

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 4.5.1) Commercial loans
The APR is set by lenders
Fees: expenses the lender will charge to lend the money
(ex.: application fees, attorney fees, origination fees)
Financial charges: cost of borrowing. They include all the
interest, fees, service charges, points, credit-related
insurance premiums, and other charges
The periodic interest rate: is the interest the lender will
charge on the amount you borrow
The term of the loan: is crucial in determing its cost

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 Two types of schemes:
Conventional amortized loan (amortized loan = a loan to be repaid in
equal periodic amounts)
Add-on loan based on the simple-interest concept

In a typical amortized loan, the amount of interest owed for a

specific period is calculated on the basis of the remaining
balance on the loan at the beginning of the period

We have: Bn, In and Pn

Two methods of calculating them:

1) Tabular method
2) Remaining balance method
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Method 1: Tabular method

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Figure 4.15 Cash flow diagram of the home improvement loan with an APR of 12% (Example 4.12).

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Figure 4.16 The proportions of principal and interest payments over the life of the loan (monthly payment = $235.37)
(Example 4.12).

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Method 2: Remaining-balance method: we
derive Bn by computing the equivalent payments remaining
after the nth payment

Figure 4.17 Calculating the remaining loan balance on the basis of method 2.
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Figure 4.18 Computing the outstanding loan balance after making the sixth payment on the home improvement loan
(Example 4.13).

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 4.5) Debt management

4.5.1) Commercial loans

4.5.2) Lease financing
4.5.3) Home mortgage

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 Home mortgage
Loan amount: the amount you actually borrow after fees and
points are deducted.
Loan term.
Payment frequency.
Points (prepaid interest): points are interest that you prepay at the
closing on your home. Each point is 1% of the loan amount.
Fees: include application fees, loan origination fees, an other
initial costs imposed by the lender.
Types of mortgages: mortgages can have either fixed or
adjustable rates (or both, in which case they are known as hybrid
mortgages)

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 Calculating monthly payments with fixed-rate
mortgages

A fully amortized mortgage: it is an installment loan in which the

principal and interest will be repaid fully through regular
installments by teh time the loans term ends.
And interest-only mortgage: the payment the borrower is
required to make consists of interest only. This option only lasts
for a specified period.
Points or no points: lenders might be willing to raise the rate by a
fraction and lower the points, or the reverse, as long as they
make the same profit.

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 Home mortgage
Figure 4.20 Comparison of interest payments between option 1 and option 2

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 Calculating monthly payments with adjustable-
rate mortgages (ARMs)

The interest rate on an ARM is make up of two parts: the

index and the margin.
An index is a guide that lenders use to measure interest rate
changes.
Example: London Interbank Offered Rate (LIBOR)

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 Libor represents the simple interest rate at which banks are willing to lend
Eurocurrency to each other.
Euribor is short for Euro Interbank Offered Rate. The Euribor rates are
based on the interest rates at which a panel of around 40/50 European
banks borrow funds from one another.

Euribor and LIBOR are comparable base rates. Euribor is the average
interbank interest rate at which European banks are prepared to lend to
one another. LIBOR is the average interbank interest rate at which a
selection of banks on the London money market are prepared to lend to
one another.

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 Margin: the percentage points added to the index rate
Adjustment period: is the period between potential interest rate
adjustments. Example: 3/1: 3 years is the initial period of the loan
during which the interest rate will stay fixed. 1 year is the
adjustment period: showing how often adjustments can be made to
the rate after the initial period has ended.
Interest rate cap: places a limit on the amount the interest can
change. There are two types of interest rate caps associated with
ARMs:
A peridic cap: limits the amount the interest rate can increase from one
adjustment period to the next
A lifetime cap: limits how much the interest rate can increase over the life of
the loan

Payment caps: limits how much the monthly payment can increase
at each adjustment

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1) What is the difference in monthly payments between these two
options?
2) Calculate the remaining balance after paying the 12th installment
of the 10th year.
3) Calculate the new installments if after year 10, the new APRs are:
4,50% and 5,25%, respectively.

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4.68) With a $400.000 home mortgage loan with a 15-year
term at 9% APR compounded monthly, compute the total
payments on principal and interest over the first five years
of ownership.

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