Lesson 03b Understanding Money

Understanding
Money
Management
NCE 4103
Equivalence Calculations with Changing Interest Rates
Compute the future worth (F) for the cash flows with
the different interest rates specified in Figure 3.10. The
cash flows occur at the end of each year over four
years.
Debt Management
Credit card debt and commercial loans are easily
among the most significant and familiar financial
obligations that involve interest. Many types of loans
are available, but here we will focus on those most
frequently used by individuals and in business.
Borrowing with Credit Cards
Paying Off Cards Saves a Bundle
Suppose that you owe $2,000 on a credit card that
charges 18% APR and you pay either the minimum
10% or $20, whichever is higher, every month. How
long will it take you to eliminate the debt? Assume
that the bank uses the previous-balance method to
calculate your interest, meaning that the bank does
not subtract the amount of your payment from the
beginning balance but charges you interest on the
previous balance.
Loan repayment schedule using Previous balance method
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Commercial Loans-Calculating Principal and Interest Payments
One of the most important applications of compound

interest involves loans that are paid off in installments
over time. If a loan is to be repaid in equal periodic
amounts (e.g., weekly, monthly, quarterly, or
annually), it is said to be an amortized loan.
Two factors determine what borrowing will cost you:
the finance charge and the length of the loan.
Using Excel to Determine a Loan's Balance, Principal, and Interest
Suppose you secure a home improvement loan in the

amount of $5,000 from a local bank. The loan officer
gives you the following loan terms:
• Contract amount = $5,000
• Contract period = 24 months
• Annual percentage rate = 12%
• Monthly installment = $235 .37
Figure 3.11 shows the cash flow diagram for this loan.
Construct the loan payment schedule by showing the
remaining balance, interest payment, and principal
payment at the end of each period over the life of
the loan.
Principal and Interest payments
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Comparing Different Financing Options
When you choose a car, you also choose how to pay
for it. If you do not have the cash on hand to buy a
new car outright-as most of us do not-you can
consider taking out a loan or leasing the car in order
to spread out the payments over time.
Your decision to pay cash, take out a loan, or sign a
lease depends on a number of personal as well as
economic factors.
Leasing is an option that lets you pay for the portion of
a vehicle you expect lo use over a specified term plus
rent charge, taxes, and fees. For example, you might
want a $20,000 vehicle. Assume that the vehicle might
be worth about $9,000 (its residual value) at the end
of a three-year lease.
Which Interest Rate Do We Use in Comparing Different Financing Options?
The dealer's (bank's) interest rate is supposed to reflect

the time value of money of the dealer (or the bank)
and is factored into the required payments. However,
the correct interest rate for us to use when comparing
financing options is the interest rate that reflects your
earning opportunity.
Which Interest Rate Do We Use in Comparing Different Financing Options?
For most individuals, this interest rate is equivalent to

the savings rate from their deposits. To illustrate, we
provide two examples. Previous Example compares
two different financing options for an automobile.
Next Example explores a lease-versus-buying decision
on an automobile.
Buying a Car: Paying in Cash versus Taking a Loan
Consider the following two options proposed by an auto
dealer:
• Option A: Purchase the vehicle at the normal price of
$26,200 and pay for the vehicle over 36 months with equal
monthly payments at 1.9% APR financing.
• Option B: Purchase the vehicle at a discounted price of
$24,048 to be paid immediately.
The funds that would be used to purchase the vehicle are
presently earning 5% annual interest compounded
monthly.
Which option is more economically sound?
Buying versus Leasing a Car
Two types of financing options are offered for an
automobile by a local dealer, as shown in the
following table.
The calculations are based on special financing
programs available at participating dealers for a
limited time. For each option, license, title, registration
fees, taxes, and insurance are extra.
For the lease option, the lessee must come up with
$731.45 at signing. This cash due at signing includes
the first month's lease payment of $236.45 and a $495
administrative fee. No security deposit is required.
However, a $300 disposition fee is due at lease end.
The lessee has the option to purchase the vehicle at
lease end for $8,673.10. The lessee is also responsible
for excessive wear and use.
If your earning interest rate is 6% compounded
monthly, which financing option is a better choice?
SUMMARY

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Lesson 03b Understanding Money

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Understanding

One of the most important applications of compound

Suppose you secure a home improvement loan in the

The dealer's (bank's) interest rate is supposed to reflect

For most individuals, this interest rate is equivalent to

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