MATH 1003 Calculus and Linear Algebra (Lecture 4)

Albert Ku

HKUST Mathematics Department

Albert Ku (HKUST) MATH 1003 1 / 19

Outline

1 Present Value of an Annuity

2 Amortization

Albert Ku (HKUST) MATH 1003 2 / 19

 Present Value of an Annuity

Present Value of an Annuity

Example
How much should you deposit in a bank account paying 6% compounded
semi-annually in order to be able to withdraw $100 every 6 months for the
next 3 years? (After the last withdrawal is made, no money is to be left in
the account.)

Remark
Obviously, you do not need to deposit $600 because part of your
future withdrawals can be covered by the interest provided.
From the bank’s viewpoint, the initial deposit can be regarded as the
present value of the annuity.

Albert Ku (HKUST) MATH 1003 3 / 19

 Present Value of an Annuity

Solution

Idea: We compute the present value of each withdrawal one by one and
sum them up.

0.06 −1
Present value of the 1st withdrawal: 100(1 + )
2
0.06 −2
Present value of the 2nd withdrawal: 100(1 + )
2
0.06 −3
Present value of the 3rd withdrawal: 100(1 + )
2
······
0.06 −6
Present value of the 6th withdrawal: 100(1 + )
2

Albert Ku (HKUST) MATH 1003 4 / 19

 Present Value of an Annuity

Therefore, the amount of inital deposit is

0.06 −1 0.06 −2 0.06 −6

100(1 + ) + 100(1 + ) + · · · + 100(1 + )
2  2 2 
0.06 −6 0.06 0.06 5
= (1 + ) 100 + 100(1 + ) + · · · + 100(1 + )
2 2 ! 2
0.06 −6 (1 + 0.06 6
2 ) −1
= (1 + ) 100 · 0.06
2 2
0.06 −6
1 − (1 + 2 )
= 100 · 0.06
= $541.72
2

Albert Ku (HKUST) MATH 1003 5 / 19

 Present Value of an Annuity

Formula for the Present Value of an Annuity

We now introduce the formula of the present value of an annuity in the

term of the notations used in finance.
Theorem
Let PV = present value of all payments(withdrawals),
PMT = periodic payment(withdrawal), i = interest rate per period and
n = number of payments(withdrawals). We have

PV = PMT (1 + i)−n + PMT (1 + i)−(n−1) + · · · + PMT (1 + i)−1

1 − (1 + i)−n
= PMT = PMTanei
i
where
1 − (1 + i)−n
anei = .
i

Albert Ku (HKUST) MATH 1003 6 / 19

 Present Value of an Annuity

Example
Recently Lion bank offered an ordinary annuity that earned 5%
compounded annually. A person plans to make equal annual deposits into
this account for 30 years in order to than make 20 equal annual
withdrawals of $25000, reducing the balance in the account to zero. How
much must be deposited annually to accumulate sufficient funds to provide
for these payments? How much total interest is earned during this entire
50-year process?

Albert Ku (HKUST) MATH 1003 7 / 19

 Present Value of an Annuity

Solution
First, we need to compute how much money is need for the person to
make 20 equal annual withdrawals of $25000. Let PMT = 25000, n = 20,
i = 0.05 and PV be the required amount of money. Then we have
1 − (1 + 0.05)−20
PV = 25000 ·
0.05

⇒ PV = $311555.2586
Then we let PMT be the annual deposit needed to accumulate
$311555.2586. We have
(1 + 0.05)30 − 1
$311555.2586 = PMT ·
0.05

⇒ PMT = $4689.35

Albert Ku (HKUST) MATH 1003 8 / 19

 Present Value of an Annuity

To compute the total interest earned in the entire 50-year process, we have

Interest earned = Total withdrawal − Total payment

= 25000 × 20 − 4689.35 × 30 = $359319.39

Albert Ku (HKUST) MATH 1003 9 / 19

 Amortization

Amortization

The formula for the present value of an annuity can also be used in the
following situation:
Example
Suppose you borrow $10000 from a bank to buy a car and agree to repay
the loan in 24 equal monthly payments, including all interest due. If the
bank charges 1% per month on the unpaid balance i.e., 12% per year
compounded monthly, how much should each payment be to retire the
total debt, including interest in 24 months?

This is called an amortization.

Albert Ku (HKUST) MATH 1003 10 / 19

 Amortization

The following two kinds of transactions between you and the bank are
basically the same:

The only difference is that the roles of “YOU” and “BANK” are
interchanged.

Albert Ku (HKUST) MATH 1003 11 / 19

 Amortization

Solution

In this example, PV = 10000 is the total loan and PMT is the amount of
the monthly payment. Then we have

1 − (1 + 0.01)−24
10000 = PMT ·
0.01

⇒ PMT = $470.73

Albert Ku (HKUST) MATH 1003 12 / 19

 Amortization

Amortization Formula

In general, amortizing a debt means that the debt is retired in a given

length of time by equal periodic payments that include compound interest.
Paying mortgage is an example. We have the following amortization
formula for PMT :
i PV
PMT = PV −n
=
1 − (1 + i) anei

Albert Ku (HKUST) MATH 1003 13 / 19

 Amortization

Mortgage

Example
A family purchased a home 10 years ago for $3000000. The home was
financed by paying 30% down and signing a 25-year mortgage at 6% on
the unpaid balance. The net market value of the house (amount received
after subtracting all costs involved in selling the house) is now $4500000,
and the family wishes to sell the house. How much equity does the family
have in the house now after making 120 monthly payments?
(note: equity = current net market value - unpaid loan balance)

Albert Ku (HKUST) MATH 1003 14 / 19

 Amortization

Solution

The total loan:

3000000 × 0.7 = $2100000
Let PMT be the monthly payment that the family made. Then we have
0.06
12
PMT = 2100000 ·
1 − (1 + 0.06
12 )
−25×12

⇒ PMT = $13530.3294
Now, we would like to calculate the unpaid loan balance of the family after
making 120 monthly payments. How can this be done?

Albert Ku (HKUST) MATH 1003 15 / 19

 Amortization

Is the unpaid balance equal to 2100000 − 13530.3294 × 120 = $476360.47?

The answer is NO!

The unpaid loan balance should be much higher because a portion of the
payments is to cover the interest.

Assume that the family does not sell the house and continue to make
25 × 12 − 120 = 180 payments until the loan is repaid.

We can say that those 180 payments will amortize the unpaid loan
balance, or equivalently, the unpaid loan balance is the present value of
those 180 payments.

Albert Ku (HKUST) MATH 1003 16 / 19

 Amortization

Therefore, the unpaid loan balance is

0.06 −180
1 − (1 + 12 )
13530.3294 × 0.06
12

= $1603391.59
Since the equity = current net market value - unpaid loan balance, we have

Equity = 4500000 − 1603391.59 = $2896608.41

Albert Ku (HKUST) MATH 1003 17 / 19

 Amortization

Car Financing

Example
You want to buy a new car with a price of $1764000 and you have to
choose between 0% financing for 48 months or a $21000 rebate. If you
choose the rebate, you can obtain a loan for the balance at 4.5%
compounded monthly for 48 months at your bank. Which option should
you choose?

Albert Ku (HKUST) MATH 1003 18 / 19

 Amortization

Solution

Since both ways of car financing involve 48 payments, we just need to

compare their monthly payments.

1764000
For the 0% financing scheme, the monthly payment is = $36750.
48

For the rebate scheme, let PMT be the monthly payment. Using the
amortization formula, we have
0.045
12
PMT = (1764000 − 21000) ·
1 − (1 + 0.045
12 )
−48

⇒ PMT = $39746.48
Therefore, you should choose the 0% financing scheme.

Albert Ku (HKUST) MATH 1003 19 / 19