Consumer Mathematics 

What Is an Interest Rate?

The interest rate is the amount a lender charges a borrower and is a percentage
of the principal—the amount loaned. The interest rate on a loan is typically noted on
an annual basis known as the annual percentage rate (APR).

An interest rate can also apply to the amount earned at a bank or credit union
from a savings account or certificate of deposit (CD). Annual percentage yield
(APY) refers to the interest earned on these deposit accounts.

The interest rate is the amount charged on top of the principal by a lender to a
borrower for the use of assets.

An interest rate also applies to the amount earned at a bank or credit union
from a deposit account.

Most mortgages use simple interest. However, some loans use compound
interest, which is applied to the principal but also to the accumulated interest of
previous periods.

A borrower that is considered low risk by the lender will have a lower interest
rate. A loan that is considered high risk will have a higher interest rate.

Consumer loans typically use an APR, which does not use compound interest.

The APY is the interest rate that is earned at a bank or credit union from a
savings account or CD. Savings accounts and CDs use compounded interest.

Understanding Interest Rates

Interest is essentially a charge to the borrower for the use of an asset. Assets
borrowed can include cash, consumer goods, vehicles, and property.

Simple Interest Rate

The example above was calculated based on the annual simple interest
formula, which is:

Simple interest = principal X interest rate X time

The individual that took out a mortgage will have to pay $12,000 in interest at
the end of the year, assuming it was only a one-year lending agreement. If the term of
the loan was for 30 years, the interest payment will be:

Simple interest = $300,000 X 4% X 30 = $360,000

 An annual interest rate of 4% translates into an annual interest payment of
$12,000. After 30 years, the borrower would have made $12,000 x 30 years =
$360,000 in interest payments, which explains how banks make their money.

Compound Interest Rate

Some lenders prefer the compound interest method, which means that the
borrower pays even more in interest. Compound interest, also called interest on
interest, is applied to the principal but also on the accumulated interest of previous
periods. The bank assumes that at the end of the first year the borrower owes the
principal plus interest for that year. The bank also assumes that at the end of the
second year, the borrower owes the principal plus the interest for the first year plus
the interest on interest for the first year.

The interest owed when compounding is higher than the interest owed using
the simple interest method. The interest is charged monthly on the principal including
accrued interest from the previous months. For shorter time frames, the calculation of
interest will be similar for both methods. As the lending time increases, however, the
disparity between the two types of interest calculations grows.

Using the example above, at the end of 30 years, the total owed in interest is
almost $700,000 on a $300,000 loan with a 4% interest rate.

The following formula can be used to calculate compound interest:

Compound interest = p X [(1 + interest rate)n − 1]

where:

p = principal n = number of compounding periods

Compound Interest and Savings Accounts

When you save money using a savings account, compound interest is

favorable. The interest earned on these accounts is compounded and is compensation
to the account holder for allowing the bank to use the deposited funds.

If, for example, you deposit $500,000 into a high-yield savings account, the
bank can take $300,000 of these funds to use as a mortgage loan. To compensate you,
the bank pays 1% interest into the account annually. So, while the bank is taking 4%
from the borrower, it is giving 1% to the account holder, netting it 3% in interest. In
effect, savers lend the bank money which, in turn, provides funds to borrowers in
return for interest.

The snowballing effect of compounding interest rates, even when rates are at
rock bottom, can help you build wealth over time; Investopedia Academy's Personal
Finance for Grads course teaches how to grow a nest egg and make wealth last.

Borrower's Cost of Debt

 While interest rates represent interest income to the lender, they constitute a
cost of debt to the borrower. Companies weigh the cost of borrowing against the cost
of equity, such as dividend payments, to determine which source of funding will be
the least expensive. Since most companies fund their capital by either taking on debt
and/or issuing equity, the cost of the capital is evaluated to achieve an optimal capital
structure.

APR vs. APY

Interest rates on consumer loans are typically quoted as the annual percentage
rate (APR). This is the rate of return that lenders demand for the ability to borrow
their money. For example, the interest rate on credit cards is quoted as an APR. In our
example above, 4% is the APR for the mortgage or borrower. The APR does not
consider compounded interest for the year.

The annual percentage yield (APY) is the interest rate that is earned at a bank
or credit union from a savings account or CD. This interest rate takes compounding
into account.

Factors Affecting Interest Rates

 1. Forces of demand and supply Interest rates are influenced by the
demand for, and supply of, credit in an economy. An increase in demand for credit
eventually leads to a rise in interest rates, or the price of borrowing. Conversely, a rise
in the supply of credit leads to a decline in interest rates. The credit supply increases
when the total amount of money that’s borrowed goes up.

For example, when money is deposited in banks, it is in turn used by banks for
investment activities or to lend it elsewhere. As banks lend more money, there is more
credit available, and thus borrowing increases. When this occurs, the cost of
borrowing decreases (due to normal supply and demand economics).

2. Inflation The higher the inflation rate, the higher interest rates rise. That
is because interest earned on money loaned must compensate for inflation. As
compensation for a decline in the purchasing power of money that they will be repaid
in the future, lenders charge higher interest rates.

  3. Government In some cases, the government’s monetary policy

influences the amount of interest rates. Also, when the government buys more
securities, banks are injected with more money to be used for lending, and thus
interest rates decrease. When the government sells these securities, money from the
banks gets drained, giving banks less money for lending purposes and leading to a rise
in interest rates.

How to use the compound interest formula

To use the compound interest formula you will need figures for principal amount,
annual interest rate, time factor and the number of compound periods. Once you have
those, you can go through the process of calculating compound interest.
 The formula for compound interest, including principal sum, is:
A = P (1 + r/n) (nt)

Where:

 A = the future value of the investment/loan, including interest

 P = the principal investment amount (the initial deposit or loan amount)
 r = the annual interest rate (decimal)
 n = the number of times that interest is compounded per unit t
 t = the time the money is invested or borrowed for

It's worth noting that this formula gives you the future value of an investment or loan,
which is compound interest plus the principal. Should you wish to calculate the
compound interest only, you need to deduct the principal from the result. So, your
formula looks like this:

Compounded interest only (without principal): P (1 + r/n) (nt) - P

Let's look at an example

If an amount of $5,000 is deposited into a savings account at an annual interest rate of

5%, compounded monthly, the value of the investment after 10 years can be
calculated as follows...

P = 5000.
r = 5/100 = 0.05 (decimal).
n = 12.
t = 10.

If we plug those figures into the formula, we get the following:

A = 5000 (1 + 0.05 / 12) (12 * 10) = 8235.05.

So, the investment balance after 10 years is $8,235.05.

What is meant by Compound Interest?

Compound interest is the interest paid on both principal and interest,

compounded at regular intervals. At regular intervals, the interest so far accumulated
is clubbed with the existing principal amount and then the interest is calculated for the
new principal. The new principal is equal to the sum of the Initial principal, and the
interest accumulated so far.

Compound Interest = Interest on Principal + Compounded Interest at Regular

Intervals
 The compound interest is calculated at regular intervals like annually(yearly),
semi-annually, quarterly, monthly, etc; It is like, re-investing the interest income from
an investment makes the money grow faster over time! It is exactly what the
compound interest does to the money. Banks or any financial organization calculate
the amount based on compound interest only. 

Compound Interest Formula

The compound interest is calculated, after calculating the total amount over a
period of time, based on the rate of interest, and the initial principal. For an initial
principal of P, rate of interest per annum of r, time period t in years, frequency
of the number of times the interest is compounded annually n, the formula for
calculation of amount is as follows. 

The above formula represents the total amount at the end of the time period and
includes the compounded interest and the principal. Further, we can calculate the
compound interest by subtracting the principal from this amount. The formula for
calculating the compound interest is as follows 

In the above expression,

 P is the principal amount

 r is the rate of interest(decimal)
 n is frequency or no. of  times the interest is compounded annually
 t is the overall tenure.

It is to be noted that the above-given formula is the general formula when the
principal is compounded n number of times in a year. If the given principal is
compounded annually, the amount after the time period at percent rate of interest, r, is
given as:

A = P(1 + r/100)t, and C.I. would be: P(1 + r/100)t - P .

Derivation of Compound Interest Formula

The formula for compound interest can be derived from the formula for simple
interest. The formula for simple interest is the product of the principal, time period,
and rate of interest (SI = ptr/100). Before looking into to derivation of the formula for
compound interest, let us understand the basic difference between simple interest,
compound interest computation. The principal remains constant over a period of time,
for simple internet computation, but for compound interest computation the interest is
added to the principal, for compound interest computation.

Derivation: 

Let the principal is P and the rate of interest be r. At the end of the first compounding
period, the simple interest on the principal is P × r/100. And hence, the amount is P +
P × r/100 = P(1 + r/100). The amount is taken as the principal for the second
computation period.  

At the end of the second compounding period, the simple interest on the principal
is: P(1 + r/100) × r/100, and hence the amount is: P(1 + r/100) × r/100 + P(1 +
r/100) × r/100 = P(1 + r/100)2.

Continuing in this manner for n compounding periods, the amount at the end of
the nth compounding period is A =  P(1 + r/100)n. 

From the above formulas and computations, you can observe that the compound
interest is the same as simple interest for the first interval. But, over a period of time,
there is a remarkable difference in returns. 

The simple interest value for each of the years is the same, as the principal on which it
is calculated is constant. But the compound interest is varying and increasing across
the years. Because the principal on which the compound interest is calculated is
increasing. The principal for a particular year is equal to the sum of the initial
principal value, and the accumulated interest of the past years. 
For example, a sum of $10,000 is deposited at a rate of 10%. The below table explains
the difference between simple interest and compound interest computation on this
principal:

Simple Interest Calculation (r = Compound Interest Calculation(r =

10%) 10%)

For 1st year: For 1st year:

P = 10,000 P = 10,000

Time = 1 year Time = 1 year

Interest = 1000 Interest = 1000

For 2nd year: For 2nd year:

P = 10,000 P = 11000

Time = 1 year Time = 1 year

Interest = 1000 Interest = 1100

For 3rd year: For 3rd year:

P = 10,000 P = 12100

Time = 1 year Time = 1 year

Interest = 1000 Interest = 1210

For 4th year: For 4th year:

P = 10,000 P = 13310

Time = 1 year Time = 1 year

Interest = 1000 Interest = 1331

For 5th year: For 5th year:

P = 10,000 P = 14641
 Time = 1 year Time = 1 year

Interest = 1000 Interest = 1464.1

Total Simple Interest = 5000 Total Compount Interest = 6105.1

Total Amount = 1000 + 5000 = Total Amount = 1000 + 6105.1 =

6000 7105.1

Compound Interest Formula for Different Time Periods

Compound interest for a given principal can be calculated for different time periods
using different formulas.
Compound Interest Formula - Half Yearly

The interest in the case of compound interest varies based on the period of

computation. If the time period for the calculation of interest is half-yearly, the
interest is calculated every six months, and the amount is compounded twice a year. 

The formula to calculate the compound interest when the principal is compounded
semi-annually or half-yearly is given as:

Here the compound interest is calculated for the half-yearly period, and hence the rate
of interest r, is divided by 2 and the time period is doubled. The formula to calculate
the amount when the principal is compounded semi-annually or half-yearly is given
by: 
In the above expression,

 A is the amount at the end of the time period

 P is the initial principal value, r is the rate of interest per annum
 t is the time period
 C.I. is the compound interest.
Compound Interest Formula - Quarterly 

If the time period for the calculation of interest is quarterly, the interest is calculated
for every three months, and the amount is compounded 4 times a year. The formula to
calculate the compound interest when the principal is compounded quarterly is given
as:

Here the compound interest is calculated for the quarterly time period, and hence the
rate of interest r, is divided by 4 and the time period is quadrupled. The formula to
calculate the amount when the principal is compounded quarterly is given by: 
In the above expression,

 A is the amount at the end of the time period

 P is the initial principal value, r is the rate of interest per annum
 t is the time period
 C.I. is the compound interest.

Monthly Compound Interest Formula

The monthly compound interest formula is also known as the interest calculated per
month i.e., n = 12. Total compound interest is the final amount excluding the principal
amount. The monthly compound interest formula is expressed as:
CI = P (1 + r/12)12t - P

Daily Compound Interest Formula

When the amount compounds daily, it means that the amount compounds 365 times in
a year. i.e., n = 365. The daily compound interest formula is expressed as:
CI = P (1 + r/365)365t - P

Important Notes

1. Compound interest depends on the amount accumulated at the end of

the previous tenure but not on the original principal. 
2. Banks, insurance companies, etc. generally levy compound interest.
3. If the interest is compounded quarterly, the formula of amount is given
by:A=P(1+r/4100)4nA=P(1+r/4100)4n 
4. While calculating the compound interest, the rate of interest, and each time
period must be of the same duration.

Simple Interest Formula

Simple interest is calculated with the following formula: S.I. = P × R × T, where P =
Principal, R = Rate of Interest in % per annum, and T = Time, usually calculated as
the number of years. The rate of interest is in percentage r% and is to be written as
r/100.

 Principal: The principal is the amount that initially borrowed from the bank
or invested. The principal is denoted by P.
 Rate: Rate is the rate of interest at which the principal amount is given to
someone for a certain time, the rate of interest can be 5%, 10%, or 13%, etc. The
rate of interest is denoted by R.
 Time: Time is the duration for which the principal amount is given to
someone. Time is denoted by T.
 Amount: When a person takes a loan from a bank, he/she has to return the
principal borrowed plus the interest amount, and this total returned is called
Amount.

Amount = Principal + Simple Interest

A = P + S.I.

A = P + PRT

A = P(1 + RT)

Simple Interest Example: 

Michael's father had borrowed $1,000 from the bank and the rate of interest was 5%.
What would the simple interest be if the amount is borrowed for 1 year? Similarly,
calculate the simple interest if the amount is borrowed for 2 years, 3 years, and 10
years?

Solution:

Principal Amount = $1,000, Rate of Interest = 5% = 5/100. (Add a sentence here

describing the given information in the question.)
   Simple Interest

1
S.I = (1000 ×5 × 1)/100
Yea
= 50
r

2
S.I = (1000 × 5 × 2)/100
Yea
= 100
r

3
S.I = (1000 ×5 × 3)/100
Yea
= 150
r

10
S.I = (1000 × 5 ×
Yea
10)/100 = 500
r

Now, we can also prepare a table for the above question adding the amount to be
returned after the given time period.

  Simple Interest Amount

1
S.I = (1000 ×5
Yea A= 1000 + 50 = 1050
× 1)/100 = 50
r

2
S.I = (1000 ×5
Yea A= 1000 + 100 = 1100
× 2)/100 = 100
r

3
S.I = (1000 × 5
Yea A = 1000 + 150 = 1150
× 3)/100 = 150
r

10
S.I = (1000 × 5
Yea A = 1000 + 500 = 1500
× 10)/100 = 500
r

What Types of Loans use Simple Interest?

Most banks these days apply compound interest on loans because in this way banks
get more money as interest from their customers, but this method is more complex
and hard to explain to the customers. On the other hand, calculations become easy
when banks apply simple interest methods. Simple interest is much useful when a
customer wants a loan for a short period of time, for example, 1 month, 2 months, or 6
months.

When someone goes for a short-term loan using simple interest, the interest applies on
a daily or weekly basis instead of a yearly basis. Consider that you borrowed
$10,000 on simple interest at a 10% interest rate per year, so this 10% a year rate
divide into a rate per day which is equal to 10/365 = 0.027%. So you have to pay
$2.73 a day extra on $10,000.

Simple Interest vs Compound Interest

Simple interest and compound interest are two ways to calculate interest on a loan
amount. It is believed that compound interest is more difficult to calculate than simple
interest because of some basic differences in both. Let's understand the difference
between simple interest and compound interest through the table given below:

Simple Interest Compound Interest

Simple interest is Compound interest is

calculated on the calculated on the
original principal accumulated sum of
amount every time. principal and interest.

It is calculated
It is calculated using the
using the following
following formula: C.I.= P
formula: S.I.= P ×
× (1+r)t - P
R×T

It is different for every span

It is equal for every
of the time period as it is
year on a certain
calculated on the amount
principal.
and not principal.

Simple Interest: Tips and Tricks

 To find the time period, the day on which money is borrowed is not taken into
account, but the day on which money has to be returned is counted.
 The rate of interest is the interest on every $100 for a fixed time period.
 Interest is always more in the case of compound interest as compared to
simple interest.
 The formula or methods to calculate compound interest is derived from simple
interest calculation methods.
 Rate of interest is always kept in fractions in the formula.

Think Tank:

 What if a bank provides you an interest such that your money doubles every
day, if you invested $1 on day 1, in how many days you will become a
billionaire?
 Will you invest if a bank provides a negative rate of interest?

Examples Using Future Value Simple Interest Formula

Example1: If Sam lends $1,500 to his friend at an interest rate of 4.3%. Find the
future value after 6 years by using future value simple interest formula?

Solution:  To find: The future value after 6 years.

P = 1500, r = 0.043 (4.3%), and t = 6 (given)

Using  Future Value Simple Interest Formula,

F V = P + I or F V = P(1 + rt)

Put the values,

F V = 1500 + I or F V = 1500(1 + 0.043 × 6)

F V = 1500(1 + 0.258)

F V = 1500(1.258)

F V = 1500(1.258)

F V = 1887

Answer: The future value after 6 years will be $1887.

Example 2: James borrowed $600 from the bank at some rate and that future
value becomes quadruple in 4 years. Calculate the rate at which James borrowed the
money by using future value simple interest formula.

Solution: To find: Interest rate

P = 600, FV = 2400, and t = 4(given)

Using formula,

F V = P + I or F V = P(1 + rt)

2400 = 600 + I or F V = 600(1 + r × 4)

2400 = 600 + 2400r

1800 = 2400r

r = 1800/2400

r = 0.75%

Answer: The Interest rate on the given amount of money is 75%.

Formulae to find compound interest rate, time and principal

It may be that you want to manipulate the compound interest formula to work
out the interest rate for IRR or CAGR, or a principal investment/loan figure. Here are
the formulae you need.

Formula for interest rate (r)

Should you wish to work out the yearly interest rate you're getting on your
savings, investment, personal loan or car loan, this formula can help. Note that you
should multiply your result by 100 to get a percentage figure (%)
How to calculate interest rate
Formula for principal (P)
This formula is useful if you want to work backwards and find out how much you
would need to start with in order to achieve a chosen future value.
How to calculate principal (starting amount)
Example: Let's say your goal is to end up with $10,000 in 5 years, and you can get an
8% interest rate on your savings, compounded monthly. Your calculation would be: P
= 10000 / (1 + 0.08/12)(12×5) = $6712.10. So, you would need to start off with
$6712.10 to achieve your goal.
Formula for time (t)
This variation of the formula works for calculating time (t), by using natural
logarithms. You can see how this formula was worked out by reading this explanation
on [Link].
t = ln(A/P) / n[ln(1 + r/n)]
Where:
A = the value of the accrued investment/loan
P = the principal amount
r = the annual interest rate (decimal)
n = the number of times that interest is compounded per unit t
t = the time the money is invested or borrowed for
Compound interest formula (with regular contributions)
A lot of people have asked me to include a single formula for compound
interest with monthly additions. Believe me when I tell you that it isn't quite as simple
as it sounds. In order to work out calculations involving monthly additions, you will
need to use two formulae - our original one, listed above, plus the 'future value of a
series' formula for the monthly additions.
Compound interest for principal:
P(1+r/n)(nt)
Future value of a series:
PMT × {[(1 + r/n)(nt) - 1] / (r/n)}
If the additional deposits are made at the BEGINNING of the period
(beginning of year, etc), here are the two formulae you will need:
Compound interest for principal:
P(1+r/n)(nt)
Future value of a series:
PMT × {[(1 + r/n)(nt) - 1] / (r/n)} × (1+r/n)
Where:
A = the future value of the investment/loan, including interest
P = the principal investment amount (the initial deposit or loan amount)
PMT = the monthly payment
 r = the annual interest rate (decimal)
n = the number of times that interest is compounded per unit t
t = the time (months, years, etc) the money is invested or borrowed for
Example
If an amount of $5,000 is deposited into a savings account at an annual interest rate of
5%, compounded monthly, with additional deposits of $100 per month (made at the
end of each month). The value of the investment after 10 years can be calculated as
follows...
P = 5000. PMT = 100. r = 5/100 = 0.05 (decimal). n = 12. t = 10.
If we plug those figures into the formulae, we get:
Total = [ Compound interest for principal ] + [ Future value of a series ]
Total = [ P(1+r/n)^(nt) ] + [ PMT × (((1 + r/n)^(nt) - 1) / (r/n)) ]
Total = [ 5000 (1 + 0.05 / 12) ^ (12 × 10) ] + [ 100 × (((1 + 0.00416)^(12 × 10) - 1) /
(0.00416)) ]
Total = [ 5000 (1.00416) ^ (120) ] + [ 100 × (((1.00416^120) - 1) / 0.00416) ]
Total = [ 8235.05 ] + [ 100 × (0.647009497690848 / 0.00416) ]
Total = [ 8235.05 ] + [ 15528.23 ]
Total = [ $23,763.28 ]
So, the investment balance after 10 years is $23,763.28.

Different periodic payments

A few people have requested a version of the above formula that takes into account
the number of periodic payments (both formulae above assume your periodic
payments match the frequency of compounding). For example, your money may be
compounded quarterly but you're making contributions monthly. In this case, you may
wish to try this version of the formula, originally suggested by Darinth Douglas, and
then expanded upon by Jean-Baptiste Delaroche. I'm most grateful for their input.
This formula assumes that regular deposits are paid at the beginning rather than at the
end of the period.
Compound interest for principal:
P(1+r/n)(nt)
Future value of a series:
 PMT × p {[(1 + r/n)(nt) - 1] / (r/n)}

(With 'p' being the number of periodic payments in the compounding period, divided
by n)
Example
An amount of $100 is deposited quarterly into a savings account at an annual
interest rate of 10%, compounded monthly. The value of the investment after 12
months can be calculated as follows...
PMT = 100. r = 0.1 (decimal). n = 12. p = 4/n = 4/12 = 0.3333333.
If we plug those figures into the formula, we get the following:
Total = PMT × p {[(1 + r/n)(nt) - 1] / (r/n)}
Total = 100 × 0.3333333 × {[(1 + 0.1 / 12) ^ (12 × 1) - 1] / (0.1 / 12)}
Total = 100 × 0.3333333 × {[1.008333 ^ (12) - 1] / 0.008333}
Total = 100 × 0.3333333 × {0.104709 / 0.008333}
Total = 100 × 0.3333333 × 12.565583
Total = 418.85
So, the investment balance after 12 months is $418.85 (or $418.84 if you round the
numbers during the calculation).

What is an Annuity?
An annuity is a financial product that provides certain cash flows at equal time
intervals. Annuities are created by financial institutions, primarily life insurance
companies, to provide regular income to a client.

An annuity is a reasonable alternative to some other investments as a source of

income since it provides guaranteed income to an individual. However, annuities are
less liquid than investments in securities because the initially deposited lump sum
cannot be withdrawn without penalties.

Upon the issuance of an annuity, an individual pays a lump sum to the issuer of the
annuity (financial institution). Then, the issuer holds the amount for a certain period
(called an accumulation period). After the accumulation period, the issuer must make
fixed payments to the individual according to predetermined time intervals.

Annuities are primarily bought by individuals who want to receive stable retirement
income.
Types of Annuities

There are several types of annuities that are classified according to frequency and
types of payments. For example, the cash flows of annuities can be paid at different
time intervals. The payments can be made weekly, biweekly, or monthly. The primary
types of annuities are:

1. Fixed annuities

Annuities that provide fixed payments. The payments are guaranteed, but the rate of
return is usually minimal.

2. Variable annuities

Annuities that allow an individual to choose a selection of investments that will pay
an income based on the performance of the selected investments. Variable annuities
do not guarantee the amount of income, but the rate of return is generally higher
relative to fixed annuities.

3. Life annuities

Life annuities provide fixed payments to their holders until his/her death.

5. Perpetuity

An annuity that provides perpetual cash flows with no end date. Examples of financial
instruments that grant perpetual cash flows to its holder are extremely rare.

Valuation of Annuities
Annuities are valued by discounting the future cash flows of the annuities and finding
the present value of the cash flows. The general formula for annuity valuation is:

Annuity Valuation Formula

Where:

PV = Present value of the annuity P = Fixed payment

r = Interest rate n = Total number of periods of annuity

payments

The valuation of perpetuity is different because it does not include a specified end
date. Therefore, the value of the perpetuity is found using the following formula:

PV = P / r

What is Annuity Formula?

The annuity formula helps in determining the values for annuity payment and
annuity due based on the present value of an annuity due, effective interest rate, and
several periods. Hence, the formula is based on an ordinary annuity that is calculated
based on the present value of an ordinary annuity, effective interest rate, and several
periods. The annuity formulas are:

Annuity = r * PVA Ordinary / [1 – (1 + r)-n]

Annuity = r * PVA Due / [{1 – (1 + r)-n} * (1 + r)]

The annuity formula for the present value of an annuity and the future value of an
annuity is very helpful in calculating the value quickly and easily. The Annuity
Formulas for future value and present value are:

The future value of an annuity, FV = P×((1+r)n−1) / r

The present value of an annuity, PV = P×(1−(1+r)-n) / r

Annuity Formula
Annuity Formula

The formula is calculated based on two important aspects - The present Value of the
Ordinary Annuity and the Present Value of the Due Annuity.

Annuity = r * PVA Ordinary / [1 – (1 + r)-n]

Where,

PVA Ordinary = Present value of an ordinary annuity

r = Effective interest rate

n = Number of periods

Annuity = r * PVA Due / [{1 – (1 + r)-n} * (1 + r)]

Where,

PVA Due = Present value of an annuity due

r = Effective interest rate

n = number of periods

The Annuity Formulas for future value and present value is:

The future value of an annuity, FV = P×((1+r)n−1) / r

The present value of an annuity, PV = P×(1−(1+r)-n) / r

where,
 P = Value of each payment

r = Rate of interest per period in decimal

n = Number of periods

Examples Using Annuity Formula

Example 1: Dan was getting $100 for 5 years every year at an interest rate of 5%.
Find the future value of this annuity at the end of 5 years? Calculate it by using the
annuity formula.

Solution

The future value

Given: r = 0.05, 5 years = 5 yearly payments, so n = 5, and P = $100

FV = P×((1+r)n−1) / r

FV = $100 × ((1+0.05)5−1) / 0.05

FV = 100 × 55.256

FV = $552.56

Therefore, the future value of annuity after the end of 5 years is $552.56.

Example 2: If the present value of the annuity is $20,000. Assuming a monthly

interest rate of 0.5%, find the value of each payment after every month for 10 years.
Calculate it by using the annuity formula.

Solution:

Given:

r = 0.5% = 0.005

n = 10 years x 12 months = 120, and PV = $20,000

Using formula for present value

PV = P×(1−(1+r)-n) / r

Or, P = PV × ( r / (1−(1+r)−n))
P = $20,000 × (0.005 / (1−(1.005)−120))

P = $20,000 × (0.005/ 1−0.54963))

P = $20,000 × 0.011...

P = $220

Therefore, the value of each payment is $220.

Example 3: Jane won a lottery worth $20,000,000 and has opted for an annuity
payment at the end of each year for the next 10 years as a payout option. Determine
the amount that Jane will be paid as annuity payment if the constant rate of interest in
the market is 5%.

Solution:

Given:

PVA (ordinary) = $20,000,000 (since the annuity to be paid at the end of each year)

r = 5% n = 10 years

Using the Annuity Formula,

Annuity = r * PVA Ordinary / [1 – (1 + r)-n]

Annuity = 5% × 20000000 / [1 - (1 + 0.05)-10

Annuity = $2,564,102.56

Therefore, Jane will pay an annuity amount of $2,564,102.56

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