Annuities and Sinking Funds

Annuities and Sinking
Funds
Sinking Funds
Sinking Funds
 A sinking fund is an account into which
periodic deposits are made.
Sinking Funds
 Usually, the deposits are made either monthly
or quarterly, although the formula allows for

any number of deposits, so long as they are
regular.
Sinking Funds
 Usually, the deposits are made either monthly
or quarterly, although the formula allows for

any number of deposits, so long as they are
regular.
 Deposits made into sinking funds earn
compound interest, and for this course we

assume the interest is compounded at the
same frequency that the deposits are made.
 With a sinking fund, each deposit will earn
interest for a different length of time.
 For example, suppose you deposit $100 per
month for one year into an account that earns

10% interest, compounded monthly.

 The first deposit (suppose it’s made January
1st) will earn interest for the full year.



 The second deposit, made February 1st, will
only earn interest for 11 months.



 The second deposit, made February 1st, will
only earn interest for 11 months.

 The third deposit will only earn interest for
10 months, etc…
 The last deposit you make, on December
first, will only earn interest for one month.
 The question is, how much money will be in
the account at the end of the year?

 The question is, how much money will be in
the account at the end of the year?

 Fortunately, there is a formula that will
answer that question for us.

 Suppose a sinking fund account has an
annual interest rate of r compounded m times
per year, so that i=r/m is the interest rate per
compounding period. If you make a payment
of PMT at the end of each period, then the
future value after t years, or n=mt periods,
will be
 Suppose a sinking fund account has an
annual interest rate of r compounded m times
per year, so that i=r/m is the interest rate per
compounding period. If you make a payment
of PMT at the end of each period, then the
future value after t years, or n=mt periods,
will be
 Note that the formula we use in this class is

for end of period deposits (so for example,
monthly deposits would be made on the last
day of the month).
 As an example, suppose we deposit $100 per
month (at the end of each month) into an
account paying 10% interest, compounded
monthly, for 2 years. How much would we
have at the end of the 2 years?
 In this case, r=0.12, m =12, and t =2. This
means that i=r/m=0.12/12=0.01, and

n=12*2=24.

n=12*2=24.
 Plugging these values into the formula gives:

n=12*2=24.

n=12*2=24.
 Thus, at the end of two years, the account
will have $2,697.35.
 Compare this to how much you would have if
you just put $100 per month into a drawer

every month for two years
($100*24=$2,400).
 Compare this to how much you would have if
you just put $100 per month into a drawer

every month for two years
($100*24=$2,400).
 The difference, $297.35, is the earned
interest. Remember that each deposit earns

interest for a different amount of time, but
the formula takes this into account and gives
the cumulative amount.
 Sometimes, we may want to know how much
we need to deposit periodically in order to
have a certain amount of money in the future.
 For this, we can rearrange the sinking fund
formula slightly to get:

 For this, we can rearrange the sinking fund
formula slightly to get:
 This formula will tell us how much a periodic

payment needs to be to have a future value of
FV in t years (where n=mt and i=r/m ).
 For example, suppose we want to have
$2,000 at the end of two years. We find an
account (a sinking fund) that will pay 6%
interest, compounded monthly. How much
do we need to deposit into the account each
month in order to have our $2,000 in two
years?
 We can use the payment formula for a sinking
fund to answer this question:
 Thus, we must deposit $78.64 every month in

order to have $2000 at the end of 2 years.
 Again, notice what happens without
compounding. If we were simply to put
$78.64 into our drawer every month for two
years, we would have only
78.64x24=1887.36 dollars. The extra
$112.64 comes from the total accumulated
interest of all of the monthly deposits, taking
into account that each deposit will earn less
interest than earlier deposits since they don’t
earn interest for as much time.
 A word about calculators:
 A word about calculators: Obviously you
have to use a calculator to use these
formulas. When you enter the previous
example into a TI-83 (or any TI calculator), it
must be entered as follows, if you want to
enter the whole thing at once:
 2000*(0.06/12)/((1+0.06/12)^(12*2)-1)
 2000*(0.06/12)/((1+0.06/12)^(12*2)-1)
 The parentheses must be exactly where you
see them here. This is to make sure that the

order of operations is satisfied.
Annuities
Annuities
 An annuity is an account which pays
compound interest, from which periodic
withdrawals are made. In this course, we
only deal with annuities in which the
withdrawals are made with the same
frequency as the compounding period.
Annuities
 An annuity is an account which pays
compound interest, from which periodic
withdrawals are made. In this course, we
only deal with annuities in which the
withdrawals are made with the same
frequency as the compounding period.
 Some common annuities are mortgages,
retirement funds, and lottery winnings.

 Consider the difference between a sinking
fund and an annuity. A sinking fund is an
account which you put money into, and an
annuity is an account which you take money
out of.
out of.
 For an annuity, you must have a relatively
large sum of money if you want to be able to

take monthly withdrawals of any worthwhile
amount.
out of.
 For an annuity, you must have a relatively
large sum of money if you want to be able to

take monthly withdrawals of any worthwhile
amount.
 The usual way people will accumulate enough
money to have an annuity is by saving for
retirement. Ideally, you save money for
several years and then when you retire, you
would like the money that you’ve saved to
earn interest, even as you take out monthly
(or other periodic) withdrawals.
 The usual way people will accumulate enough
money to have an annuity is by saving for
retirement. Ideally, you save money for
several years and then when you retire, you
would like the money that you’ve saved to
earn interest, even as you take out monthly
(or other periodic) withdrawals.
 For a few very lucky people, the money for an
annuity can come from winning a lottery or

other large gambling win.
 Regardless of how you get the money to start
an annuity, they all work in essentially the
same way.
same way.
 You start with some amount of money, and
you make periodic withdrawals of equal

amounts of money.
same way.
 You start with some amount of money, and
you make periodic withdrawals of equal

amounts of money.
 When you start the annuity, the entire initial
amount of money is earning interest. When

you take your first withdrawal, the money
that you withdraw is no longer earning
interest.
 Each withdrawal that you take no longer
earns interest, but the money that remains in
the account continues to earn interest.
 Each withdrawal that you take no longer
earns interest, but the money that remains in
the account continues to earn interest.
 A question you will need to answer is: Given
a starting amount (a present value) of an

annuity, at a given interest rate, how much
can you withdraw each month from the
annuity, so that there is nothing left after
some amount of time has passed?
 Fortunately there is a formula that we can use
to answer questions like this, it is the
payment formula for an annuity:
 In this formula, i and n are defined as they

were in a sinking fund.
 For example, suppose you have $10,000 in
an annuity that pays 12% interest,
compounded monthly. You would like to
make equal monthly withdrawals (PMT) for 5
years. How much will each withdrawal be?
 Here, i=0.12/12=0.01 and n=12*5=60.
 Here, i=0.12/12=0.01 and n=12*5=60.
 Here, i=0.12/12=0.01 and n=12*5=60.
 Here, i=0.12/12=0.01 and n=12*5=60.
 Thus, each monthly withdrawal will be

$222.44.
 Notice that 222.44x60=13,346.40, which is
more than the $10,000 you initially had in the
annuity. The interest allows you to get an
extra $3,346.40 over the course of 5 years.
 Notice that 222.44x60=13,346.40, which is
more than the $10,000 you initially had in the
annuity. The interest allows you to get an
extra $3,346.40 over the course of 5 years.
 Or, looking at it another way, if you just put
$10,000 in your drawer and took 60 equal

amounts out of it over the course of 5 years
(12 months x 5 years = 60 equal
withdrawals), you would only be able to take
out $166.67 each month. The earned
interest makes the monthly payments larger.
 In some cases, you may be interested in
finding the present value of annuity, based
on the monthly payments received from the
annuity.
 In some cases, you may be interested in
finding the present value of annuity, based
on the monthly payments received from the
annuity.
 For example, suppose you would like to make
equal monthly withdrawals of $500 over the

course of 10 years from an annuity that pays
6% interest, compounded monthly. What is
the present value of the annuity (that is, how
much money do you need to start the
annuity)?
 Here, we use the formula for the present
value of an annuity.
 Plugging in our numbers, we get




 Thus, we will need a present value of
$45,036.73 in our annuity in order to be able
to withdraw $500 per month for 10 years.
 Thus, we will need a present value of
$45,036.73 in our annuity in order to be able
to withdraw $500 per month for 10 years.
 Again, notice that if the account didn’t earn
any interest, you would need a present value

of 500x12x10=60000 dollars to be able to
take out $500 per month for 10 years. The
fact that we only need $45,036.73 is due to
the fact that we earn compound interest.
 A mortgage is a type of annuity. It is an
annuity that a bank gets from you.
 When you want to buy a house, chances are
you don’t have all the money that you need.


 A bank is (hopefully) willing to loan you the
money that you need. The loan that they give

you is an annuity.

 A bank is (hopefully) willing to loan you the
money that you need. The loan that they give

you is an annuity.
 If you look at it from the bank’s point of view,
they are putting a large sum of money into an

account that pays periodic interest.
 The bank takes monthly withdrawals from the
annuity. These monthly withdrawals are the
payments that the bank receives from you,
the borrower.
the borrower.
 We can use the payment formula for an
annuity to compute how much your monthly

payment will be on a mortgage.
the borrower.
 We can use the payment formula for an
annuity to compute how much your monthly

payment will be on a mortgage.
 For example, suppose you want to borrow
$200,000 with a 30 year mortgage to buy a

house. If the interest rate is 5%, what will
your monthly mortgage payments be?
 We use the payment formula for an annuity to
calculate our monthly payment: The present
value is 200,000.
calculate our monthly payment. The present
value is 200,000.
value is 200,000.
value is 200,000.
 Thus, the monthly mortgage payments will be

$1,073.64.
value is 200,000.
 Thus, the monthly mortgage payments will be

$1,073.64.
 The surprising thing about mortgages is how
much you actually end up paying for a house

that supposedly costs $200,000.
 It is fairly simple to figure out how much you
have actually paid the bank – you just
multiply your monthly payments by the
number of months that you pay.
 In this case, that amounts to
1,073.64x12x30=386,510.40. So for a
house that costs $200,000, you end up
paying $386,510.40. And the interest rate
here is only 5%!
 In this case, that amounts to
1,073.64x12x30=386,510.40. So for a
house that costs $200,000, you end up
paying $386,510.40. And the interest rate
here is only 5%!
 Really there is no avoiding this, unless you
can afford to buy a house without borrowing.

 Another interesting annuity is a lottery
annuity. When you see the jackpot billboard
for a lottery, the payout that they are
advertising is for a 20 year annuity.
 Another interesting annuity is a lottery
annuity. When you see the jackpot billboard
for a lottery, the payout that they are
advertising is for a 20 year annuity.
 For example, if you see that the billboard
says the jackpot is currently $20 million, that

is the total amount that you would receive,
including interest, over the course of 20
years.
 A lottery winner who chooses the lump-sum
option would not receive $20 million dollars,
since they would be taking all of the money
right now, and thus it would not include the
20 years of interest that the lottery would pay
to a person who chooses the annuity option.
 A lottery winner who chooses the lump-sum
option would not receive $20 million dollars,
since they would be taking all of the money
right now, and thus it would not include the
20 years of interest that the lottery would pay
to a person who chooses the annuity option.
 So, if you are lucky enough to win the lottery
which would you choose, the annuity option

or the lump-sum option?
 Before you decide, consider that if you take
the annuity option, the lottery is giving you
their own interest rate, which is usually fairly
low (around 4% or less per year). If you think
you could earn more interest than that with
$20 million, then you should choose the
lump-sum option.
 Before you decide, consider that if you take
the annuity option, the lottery is giving you
their own interest rate, which is usually fairly
low (around 4% or less per year). If you think
you could earn more interest than that with
$20 million, then you should choose the
lump-sum option.
 Most lottery jackpot winners choose the
lump-sum, but they are probably not

thinking too much about interest rates when
they do so!
 To summarize, we had two kinds of accounts:
sinking funds and annuities.
 To put these into perspective, consider what
a typical person does in their life. They get a

job and save a certain amount of money each
month for their working careers.
 To put these into perspective, consider what
a typical person does in their life. They get a

job and save a certain amount of money each
month for their working careers.
 The money they save each month is put into a
sinking fund, and it earns interest as

described earlier. Typically a person will do
this for 25-35 years.
 When a person decides to retire, ideally they
have saved a large amount of money in their
sinking fund.
 When a person decides to retire, ideally they
have saved a large amount of money in their
sinking fund.
 When they retire, the sinking fund changes
into an annuity. The person is no longer

putting money into the account every month
– they have now switched to taking money
out of the account each month during
retirement.
 Of course, this scenario is a greatly simplified
version of a person’s life. Most people don’t
keep the same job for life, and even if they do
they generally get raises and are able to save
more money as time goes by. Also, interest
rates for their sinking funds and annuities
will probably change over time.
 Of course, this scenario is a greatly simplified
version of a person’s life. Most people don’t
keep the same job for life, and even if they do
they generally get raises and are able to save
more money as time goes by. Also, interest
rates for their sinking funds and annuities
will probably change over time.
 However, this is a typical cycle – put money
into a sinking fund during your working life,

and then take it out of an annuity during
retirement.
 For more information on sinking funds and
annuities, see the worksheet for section 2.3
at my website,
http://www.math.utep.edu/faculty/cmmundy
 For more information on sinking funds and
annuities, see the worksheet for section 5.3
at my website,
http://www.math.utep.edu/faculty/cmmundy
 Also, read through the examples worksheet
on Blackboard.

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Annuities and Sinking

or quarterly, although the formula allows for

or quarterly, although the formula allows for

compound interest, and for this course we

month for one year into an account that earns

month for one year into an account that earns

1st) will earn interest for the full year.

month for one year into an account that earns

1st) will earn interest for the full year.

only earn interest for 11 months.

month for one year into an account that earns

1st) will earn interest for the full year.

only earn interest for 11 months.

the account at the end of the year?

the account at the end of the year?

answer that question for us.

 Note that the formula we use in this class is

means that i=r/m=0.12/12=0.01, and

means that i=r/m=0.12/12=0.01, and

means that i=r/m=0.12/12=0.01, and

means that i=r/m=0.12/12=0.01, and

you just put $100 per month into a drawer

you just put $100 per month into a drawer

interest. Remember that each deposit earns

formula slightly to get:

formula slightly to get:

 This formula will tell us how much a periodic

 Thus, we must deposit $78.64 every month in

see them here. This is to make sure that the

retirement funds, and lottery winnings.

large sum of money if you want to be able to

large sum of money if you want to be able to

annuity can come from winning a lottery or

you make periodic withdrawals of equal

you make periodic withdrawals of equal

amount of money is earning interest. When

a starting amount (a present value) of an

 In this formula, i and n are defined as they

 Thus, each monthly withdrawal will be

$10,000 in your drawer and took 60 equal

equal monthly withdrawals of $500 over the

 Plugging in our numbers, we get

 Plugging in our numbers, we get

 Plugging in our numbers, we get

 Plugging in our numbers, we get

any interest, you would need a present value

you don’t have all the money that you need.

you don’t have all the money that you need.

money that you need. The loan that they give

you don’t have all the money that you need.

money that you need. The loan that they give

they are putting a large sum of money into an

annuity to compute how much your monthly

annuity to compute how much your monthly

$200,000 with a 30 year mortgage to buy a

 Thus, the monthly mortgage payments will be

 Thus, the monthly mortgage payments will be

much you actually end up paying for a house