Copyright © 2011 Pearson Education, Inc. Managing Your Money

4A Discussion Questions 1. How do you feel about the homeowner’s total percentage mentioned in #2 of the Analysis? What do financial experts recommend? 2. How do you feel about the total vehicle percentage in #3 of the Analysis? How would you find the line between affordable and not affordable in terms of a vehicle? 3. Reflect on the personal impressions you put together the Davidson’s original budget and how this activity might impact your future financial decisions. Copyright © 2011 Pearson Education, Inc.

Slide 4-4 Unit 4B: Part 1 The Power of Compounding King Edward’s debt after 535 years….

Simple Vs. Compound Interest Honest John’s Money Holding Service Pays 5% interest each year You deposit $1000 Over 3 years you receive simple interest of ____ Only paid on principal of ______ Copyright © 2011 Pearson Education, Inc. Slide 4-5

4-B Copyright © 2011 Pearson Education, Inc. Slide 4-6 Definitions The principal in financial formulas is the balance upon which interest is paid. Simple interest is interest paid only on the original principal, and not on any interest added at later dates. Compound interest is interest paid on both the original principal and on all interest that has been added to the original principal.

4-B CN (1-2) Savings Bond While banks almost always pay compound interest, bonds usually pay simple interest. Suppose you invest $1000 in a savings bond that pays simple interest of 10% per year. 1. How much total interest will you receive in 5 years? 2. If the bond paid compound interest would your receive more or less total interest? Explain Copyright © 2011 Pearson Education, Inc. Slide 4-7

4-B Brief Review: Powers and Roots CN (3-6) Basic Powers Power Rules Basics of Roots Roots as Fractional Powers Copyright © 2011 Pearson Education, Inc. Slide 4-8

4-B The Compound Interest Formula CN (7) King Edward’s debt to the New College…. He borrowed $224 Put into an interest-bearing account for 535 years 4% per year The balance at the end of 1 year is _____ The balance at the at the end of 2 years is ____ The balance at the end of 3 years is ______ 7. Continue pattern, write the formula and the balance after 10 years: Copyright © 2011 Pearson Education, Inc. Slide 4-9

4-B Copyright © 2011 Pearson Education, Inc. Slide 4-10 A = accumulated balance after Y years P = starting principal APR = annual percentage rate (as a decimal) Y = number of years Compound Interest Formula for Interest Paid Once a Year

4-B Copyright © 2011 Pearson Education, Inc. Slide 4-11 Simple and Compound Interest Compare the growth in a $100 investment for 5 years at 10% simple interest per year and at 10% interest compounded annually. The compound interest account earns $11.05 more than the simple interest account.

4-B Results Overall, the account paying compound interest builds to $ while the simple interest account reaches only $150, even though both pay at the same 10% rate. The basic point: For the same interest rate, compound interest is always better for the investor than simple interest. Copyright © 2011 Pearson Education, Inc. Slide 4-12

4-B Standard Calculators CN (8) Excel File Standard Calculators: You can do compound interest calculations on any calculator that has key for raising numbers to powers The only “trick” is making sure you follow the standard order of operations 8. Do practice problem in a calculator The built in function FV (for future value) makes it easy to do compound interest calculations using Excel. Copyright © 2011 Pearson Education, Inc. Slide 4-13

4-B Compound Interest as Exponential Growth The New College case demonstrates the remarkable way in which money can grow with compound interest. Note that while the value rises slowly at first, it rapidly accelerates, so in later years the value grows by much more each year than it did during earlier years. Copyright © 2011 Pearson Education, Inc. Slide 4-14

4-B New College Debt at 2% CN (9-10) If the interest rate is 2%, calculate the amount due to New College using: 9. Simple interest 10. Compound interest Effects of Interest Rate Changes… You should note the remarkable effects of small changes in the compound interest rate. Copyright © 2011 Pearson Education, Inc. Slide 4-15

4-B Mattress Investments CN (11) Your grandfather put $100 under his mattress 50 years ago. If he had instead invested it in a bank account paying 3.5% interest compounded yearly (roughly the average US rate of inflation during that period), 11. How much would it be worth now? Copyright © 2011 Pearson Education, Inc. Slide 4-16

4-B 4B Part 1 Homework: P.224: Review Questions 1-8 P.224: Does it make sense : 9-14 P.224 Basic Skills: P.224 Simple Interest: odd Class Notes: 1-11 Copyright © 2011 Pearson Education, Inc. Slide 4-17

4-B 4B Part 2: p.216 Compound Interest paid more than once a year Copyright © 2011 Pearson Education, Inc. Slide 4-18

4-B Copyright © 2011 Pearson Education, Inc. Slide 4-19 Definitions Present value is the original principal. Future value is the accumulated amount.

4-B Copyright © 2011 Pearson Education, Inc. Slide 4-20 A = accumulated balance after Y years P = starting principal APR = annual percentage rate (as a decimal) n = number of compounding periods per year Y = number of years Compound Interest Formula for Interest Paid n Times per Year

4-B Copyright © 2011 Pearson Education, Inc. Slide 4-21 Compound Interest Show how quarterly compounding affects a $1000 investment at 8% per year.

4-B Copyright © 2011 Pearson Education, Inc. Slide 4-22 Definition The annual percentage yield (APY) is the actual percentage by which a balance increases in one year. It is sometimes also called the effective yield or simply the yield. APY = relative increase = absolute increase starting principal

4-B Copyright © 2011 Pearson Education, Inc. Slide 4-23 APR vs. APY APR = annual percentage rate APY = annual percentage yield APY = APR if interest is compounded annually APY > APR if interest is compounded more than once a year

4-B Copyright © 2011 Pearson Education, Inc. Slide 4-24 Continuous Compounding Show how different compounding periods affect the APY for an APR of 8%.

4-B Copyright © 2011 Pearson Education, Inc. Slide 4-25 Continuous Compounding

4-B Copyright © 2011 Pearson Education, Inc. Slide 4-26 A = accumulated balance after Y years P = starting principal APR = annual percentage rate (as a decimal) Y = number of years = a special irrational number with a value of Compound Interest Formula for Continuous Compounding