TIME VALUE OF MONEY (TVM)

INTRODUCTION
Time Value of Money (TVM) is an important concept in financial management. It can be used to
compare investment alternatives and to solve problems involving loans, mortgages, leases, savings,
and annuities.

TVM is based on the concept that a dollar that you have today is worth more than the promise or
expectation that you will receive a dollar in the future. Money that you hold today is worth more
because you can invest it and earn interest. After all, you should receive some compensation for
foregoing spending. For instance, you can invest your dollar for one year at a 6% annual interest rate
and accumulate $1.06 at the end of the year. You can say that the future value of the dollar is $1.06
given a 6% interest rate and a one-year period. It follows that the present value of the $1.06 you
expect to receive in one year is only $1.

A key concept of TVM is that a single sum of money or a series of equal, evenly-spaced payments or
receipts promised in the future can be converted to an equivalent value today. Conversely, you can
determine the value to which a single sum or a series of future payments will grow to at some future
date.

You can calculate the fifth value if you are given any four of: Interest Rate, Number of Periods,
Payments, Present Value, and Future Value. Each of these factors is very briefly defined in the right-
hand column below. The left column has references to more detailed explanations, formulas, and
examples.

Page 1 of 22
INTEREST
Interest is a charge for borrowing money, usually stated as a percentage of the amount borrowed over
a specific period of time. Simple interest is computed only on the original amount borrowed. It is
the return on that principal for one time period. In contrast, compound interest is calculated each
period on the original amount borrowed plus all unpaid interest accumulated to date. Compound
interest is always assumed in TVM problems.

Interest is the cost of borrowing money. An interest rate is the cost stated as a percent of the
amount borrowed per period of time, usually one year. The prevailing market rate is composed of:

1. The Real Rate of Interest that compensates lenders for postponing their own spending
during the term of the loan.
2. An Inflation Premium to offset the possibility that inflation may erode the value of the
money during the term of the loan. A unit of money (dollar, peso, etc) will purchase
progressively fewer goods and services during a period of inflation, so the lender must
increase the interest rate to compensate for that loss.
3. Various Risk Premiums to compensate the lender for risky loans such as those that are
unsecured, made to borrowers with questionable credit ratings, or illiquid loans that the
lender may not be able to readily resell.

The first two components of the interest rate listed above, the real rate of interest and an inflation
premium, collectively are referred to as the nominal risk-free rate. In the USA, the nominal risk-
free rate can be approximated by the rate of US Treasury bills since they are generally considered to
have a very small risk.

Simple Interest

Simple interest is calculated on the original principal only. Accumulated interest from prior
periods is not used in calculations for the following periods. Simple interest is normally used for a
single period of less than a year, such as 30 or 60 days.

Simple Interest = p * i * n

Where:
p = principal (original amount borrowed or loaned)
i = interest rate for one period
n = number of periods

Example: You borrow $10,000 for 3 years at 5% simple annual interest.

interest = p * i * n = 10,000 * .05 * 3 = 1,500

Example 2: You borrow $10,000 for 60 days at 5% simple interest per year (assume a 365 day year).

interest = p * i * n = 10,000 * .05 * (60/365) = 82.1917

Page 2 of 22
Compound Interest

Compound interest is calculated each period on the original principal and all interest
accumulated during past periods. Although the interest may be stated as a yearly rate, the
compounding periods can be yearly, semiannually, quarterly, or even continuously.

You can think of compound interest as a series of back-to-back simple interest contracts. The interest
earned in each period is added to the principal of the previous period to become the principal for the
next period. For example, you borrow $10,000 for three years at 5% annual interest compounded
annually:

interest year 1 = p * i * n = 10,000 * .05 * 1 = 500

interest year 2 = (p2 = p1 + i1) * i * n = (10,000 + 500) * .05 * 1 = 525
interest year 3 = (p3 = p2 + i2) * i * n = (10,500 + 525) *.05 * 1 = 551.25

Total interest earned over the three years = 500 + 525 + 551.25 = 1,576.25. Compare this to 1,500
earned over the same number of years using simple interest.

The power of compounding can have an astonishing effect on the accumulation of wealth. This
table shows the results of making a one-time investment of $10,000 for 30 years using 12% simple
interest, and 12% interest compounded yearly and quarterly.

Type of Interest Principal Plus Interest Earned

Simple 46,000.00
Compounded Yearly 299,599.22
Compounded Quarterly 347,109.87

You can solve a variety of compounding problems including leases, loans, mortgages, and annuities
by using the present value, future value, present value of an annuity, and future value of an annuity
formulas. See the index page to determine which of these is appropriate for your situation.

Page 3 of 22
Rate of Return

When we know the Present Value (amount today), Future Value (amount to which the investment
will grow), and Number of Periods, we can calculate the rate of return with this formula:

i = ( FV / PV) (1/n) -1

In the table above we said that the Present Value is $10,000, the Future Value is $299,599.22, and
there are 30 periods. Confirm that the annual compound interest rate is 12%.

FV = 299,599.22
PV = 10,000
n = 30

i = (299,599.22 / 10,000) 1/30 - 1 = 29.959922 .0333 - 1 = .12

Effective Rate (Effective Yield)

The effective rate is the actual rate that you earn on an investment or pay on a loan after the effects
of compounding frequency are considered. To make a fair comparison between two interest rates
when different compounding periods are used, you should first convert both nominal (or stated) rates
to their equivalent effective rates so the effects of compounding can be clearly seen.

The effective rate of an investment will always be higher than the nominal or stated interest rate
when interest is compounded more than once per year. As the number of compounding periods
increases, the difference between the nominal and effective rates will also increase.

To convert a nominal rate to an equivalent effective rate:

Effective Rate = (1 + (i / n))n - 1

Where:
i = Nominal or stated interest rate
n = Number of compounding periods per year

Example: What effective rate will a stated annual rate of 6% yield when compounded semiannually?

Effective Rate = ( 1 + .06 / 2 )2 - 1 = .0609

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Interest Rate Per Year

The Interest Rate Per Year (IY) can be solved by first finding the nominal interest rate per payment
period (i). Then, if the number of compounding periods equals the payment periods per year, you can
find the annual rate (IY) by multiplying i times the number of payments per year. If they are not
equal it becomes more complicated.

Start by substituting all known variables into the formula below. Then use the Newton-Raphson
method (see the Number of Periods formula) to choose a series of values for i until the expression
equals zero.

You can use this rate of return formula when payments are not involved.

[
0=[ PV × ( 1+ i )n ]+ PMT ×
i ]
( 1+i )n−1
+ FV

Where:

PV = Present Value
i = Interest Rate per period
n = Number of periods
PMT = Payment
FV = Future Value
Finally, when payments per year (PY) = compounding per year (CY):

IY = i x PY

Page 5 of 22
Effective Rate (Effective Yield)

The effective rate is the actual rate that you earn on an investment or pay on a loan after the effects
of compounding frequency are considered. To make a fair comparison between two interest rates
when different compounding periods are used, you should first convert both nominal (or stated) rates
to their equivalent effective rates so the effects of compounding can be clearly seen.

The effective rate of an investment will always be higher than the nominal or stated interest rate
when interest is compounded more than once per year. As the number of compounding periods
increases, the difference between the nominal and effective rates will also increase.

To convert a nominal rate to an equivalent effective rate:

Effective Rate = (1 + (i / n))n - 1

Where:
i = Nominal or stated interest rate
n = Number of compounding periods per year

Example: What effective rate will a stated annual rate of 6% yield when compounded semiannually?

Effective Rate = ( 1 + .06 / 2 )2 - 1 = .0609

The known values for nominal Interest Rate Per Year (IY) and Number of Periods (N) are substituted
into the formula below. Then different values for ie, the effective annual interest rate, are tried until
the expression equals 0. Code in the TVM component uses the Newton-Raphson method with this
formula to converge on the answer. This is a rearrangement of the effective rate formula on the
interest page.
n
0=( 1+ IY ) −1−ie

Where:

IY = Nominal Annual Interest Rate

n = Number of Periods
ie = Effective Annual Interest Rate

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NUMBER OF PERIODS
Periods are evenly-spaced intervals of time. They are intentionally not stated in years since each
interval must correspond to a compounding period for a single amount or a payment period for an
annuity.

There are straight-forward formulas for finding The Number of Periods (N) that require use of
logarithms. However, the TVM Component was developed with the Java programming language
which did not support natural logs or exponents for BigDecimal numbers at the time, so this alternate
method was used instead. Values of all the known variables are substituted into the formula given
below. Then different values for the remaining variable N are tried until the expression equals zero.
The Newton-Raphson method is used to choose a series of values to try. This method converges on
the answer with reasonably few attempts.

[
0=[ PV × ( 1+ i )n ]+ PMT ×
i ]
( 1+i )n−1
+ FV

Where:

PV = Present Value
i = Interest Rate per period
n = Number of periods
PMT = Payment
FV = Future Value

The variable n in Time Value of Money formulas represents the number of periods. It is
intentionally not stated in years since each interval must correspond to a compounding period for a
single amount or a payment period for an annuity.

The interest rate and number of periods must both be adjusted to reflect the number of compounding
periods per year before using them in TVM formulas. For example, if you borrow $1,000 for 2 years
at 12% interest compounded quarterly, you must divide the interest rate by 4 to obtain rate of
interest per period (i = 3%). You must multiply the number of years by 4 to obtain the total number
of periods ( n = 8).

You can determine the number of periods required for an initial investment to grow to a specified
amount with this formula:

number of periods = natural log [(FV * i) / (PV * i)] / natural log (1 + i)

Where:
PV = present value, the amount you invested
FV = future value, the amount your investment will grow to
i = interest per period
Page 7 of 22
Example: You put $10,000 into a savings account at a 9.05% annual interest rate compounded
annually. How long will it take to double your investment?

LN [(20,000 * .0905) / (10,000 * .0905)] / LN (1 .0905) =

LN (2) / LN (1.0905) =.69314 / . 08663 = 8 years

Number of Periods

There are straight-forward formulas for finding The Number of Periods (N) that require use of
logarithms. However, the TVM Component was developed with the Java programming language
which did not support natural logs or exponents for BigDecimal numbers at the time, so this alternate
method was used instead. Values of all the known variables are substituted into the formula given
below. Then different values for the remaining variable N are tried until the expression equals zero.
The Newton-Raphson method is used to chose a series of values to try. This method converges on
the answer with reasonably few attempts.

[
0=[ PV × ( 1+ i )n ]+ PMT ×
i ]
( 1+i )n−1
+ FV

Where:

PV = Present Value
i = Interest Rate per period
n = Number of periods
PMT = Payment
FV = Future Value

The variable n in Time Value of Money formulas represents the number of periods. It is
intentionally not stated in years since each interval must correspond to a compounding period for a
single amount or a payment period for an annuity.

The interest rate and number of periods must both be adjusted to reflect the number of compounding
periods per year before using them in TVM formulas. For example, if you borrow $1,000 for 2 years
at 12% interest compounded quarterly, you must divide the interest rate by 4 to obtain rate of
interest per period (i = 3%). You must multiply the number of years by 4 to obtain the total number
of periods ( n = 8).

Page 8 of 22
You can determine the number of periods required for an initial investment to grow to a specified
amount with this formula:

number of periods = natural log [(FV * i) / (PV * i)] / natural log (1 + i)

Where:
PV = present value, the amount you invested
FV = future value, the amount your investment will grow to
i = interest per period

Example: You put $10,000 into a savings account at a 9.05% annual interest rate compounded
annually. How long will it take to double your investment?

LN [(20,000 * .0905) / (10,000 * .0905)] / LN (1 .0905) =

LN (2) / LN (1.0905) =.69314 / . 08663 = 8 years

Page 9 of 22
PAYMENTS
Payments are a series of equal, evenly-spaced cash flows. In TVM applications, payments must
represent all outflows (negative amount) or all inflows (positive amount).

Annuity Payments
Payments in Time Value of Money formulas are a series of equal, evenly-spaced cash flows of an
annuity such as payments for a mortgage or monthly receipts from a retirement account.

Payments must:

 be the same amount each period

 occur at evenly spaced intervals
 occur exactly at the beginning or end of each period
 be all inflows or all outflows (payments or receipts)
 represent the payment during one compounding (or discount) period

Calculate Payments When Present Value Is Known

The Present Value is an amount that you have now, such as the price of property that you have just
purchased or the value of equipment that you have leased. When you know the present value,
interest rate, and number of periods of an ordinary annuity, you can solve for the payment with this
formula:

payment = PVoa / [(1- (1 / (1 + i)n )) / i]

Where:
PVoa = Present Value of an ordinary annuity (payments are made at the end of each period)
i = interest per period
n = number of periods

Example: You can get a $150,000 home mortgage at 7% annual interest rate for 30 years.
Payments are due at the end of each month and interest is compounded monthly. How much will
your payments be?

PVoa = 150,000, the loan amount

i = .005833 interest per month (.07 / 12)
n = 360 periods (12 payments per year for 30 years)

payment = 150,000 / [(1 - ( 1 / (1.005833)360)) / .005833] = 997.95

Page 10 of 22
Calculate Payments When Future Value Is Known

The Future Value is an amount that you wish to have after a number of periods have passed. For
example, you may need to accumulate $20,000 in ten years to pay for college tuition. When you
know the future value, interest rate, and number of periods of an ordinary annuity, you can solve for
the payment with this formula:

payment = FVoa / [((1 + i)n - 1 ) / i]

Where:
FVoa = Future Value of an ordinary annuity (payments are made at the end of each period)
i = interest per period
n = number of periods

Example: In 10 years, you will need $50,000 to pay for college tuition. Your savings account pays
5% interest compounded monthly. How much should you save each month to reach your goal?

FVoa = 50,000, the future savings goal

i = .004167 interest per month (.05 / 12)
n = 120 periods (12 payments per year for 10 years)

payment = 50,000 / [(1.004167120 - 1) / .004167] = 321.99

Payment

[
PMT = PV +
PV + FV
]
( 1+ i )n −1
×i

Where:

PMT = Payment
PV = Present Value
FV = Future Value
i = Interest Rate per period
n = Number of periods

Page 11 of 22
Example: You are 65 years old and have saved $400,000 for retirement. You believe you will live 20
more years. You want to leave $100,000 to your family. You can invest at a nominal annual rate of
6% compounded monthly. What amount can you withdraw at the end of each month and still reach
all your goals?

PV = -400,000 (negative amount paid out (deposited))

FV = 100,000 (positive amount withdrawn after 20 years)
n = 240 (20 years x 12 months per year)
i = .005 (.06/12 annual rate / 12 months per year)
PMT = ? (positive amount withdrawn monthly)
PMT = [-400000 + ((-400000 + 100000) / (1.005 240 - 1]))] * -.005
PMT = [-400000 + (-300000 / (3.3102 -1))] * -.005
PMT = [-400000 + -129858.8887] * -.005
PMT = 2,649.29

You can work through the example again with an online calculator that uses this formula.

Page 12 of 22
PRESENT VALUE

Present Value is an amount today that is equivalent to a future payment, or series of payments, that
has been discounted by an appropriate interest rate. The future amount can be a single sum that will
be received at the end of the last period, as a series of equally-spaced payments (an annuity), or
both. Since money has time value, the present value of a promised future amount is worth less the
longer you have to wait to receive it.

Present Value Of A Single Amount

Present Value is an amount today that is equivalent to a future payment, or series of payments, that
has been discounted by an appropriate interest rate. Since money has time value, the present value of
a promised future amount is worth less the longer you have to wait to receive it. The difference
between the two depends on the number of compounding periods involved and the interest
(discount) rate.

The relationship between the present value and future value can be expressed as:

PV = FV [ 1 / (1 + i)n ]

Where:

PV = Present Value
FV = Future Value
i = Interest Rate Per Period
n = Number of Compounding Periods

Example: You want to buy a house 5 years from now for $150,000. Assuming a 6% interest rate
compounded annually, how much should you invest today to yield $150,000 in 5 years?

FV = 150,000
i =.06
n=5

PV = 150,000 [ 1 / (1 + .06)5 ] = 150,000 (1 / 1.3382255776) = 112,088.73

End of Year 1 2 3 4 5
Principal 112,088.73 118,814.05 125,942.89 133,499.46 141,509.43
Interest 6,725.32 7,128.84 7556.57 8,009.97 8,490.57
Total 118,814.05 125,942.89 133,499.46 141,509.43 150,000.00

Page 13 of 22
Example 2: You find another financial institution that offers an interest rate of 6% compounded
semiannually. How much less can you deposit today to yield $150,000 in five years?

Interest is compounded twice per year so you must divide the annual interest rate by two to obtain
a rate per period of 3%. Since there are two compounding periods per year, you must multiply the
number of years by two to obtain the total number of periods.

FV = 150,000
i = .06 / 2 = .03
n = 5 * 2 = 10

PV = 150,000 [ 1 / (1 + .03)10] = 150,000 (1 / 1.343916379) = 111,614.09

Present Value of Annuities

An annuity is a series of equal payments or receipts that occur at evenly spaced intervals. Leases and
rental payments are examples. The payments or receipts occur at the end of each period for an
ordinary annuity while they occur at the beginning of each period.for an annuity due.

Present Value of an Ordinary Annuity

The Present Value of an Ordinary Annuity (PVoa) is the value of a stream of expected or
promised future payments that have been discounted to a single equivalent value today. It is
extremely useful for comparing two separate cash flows that differ in some way.

PV-oa can also be thought of as the amount you must invest today at a specific interest rate so that
when you withdraw an equal amount each period, the original principal and all accumulated interest
will be completely exhausted at the end of the annuity.

The Present Value of an Ordinary Annuity could be solved by calculating the present value of each
payment in the series using the present value formula and then summing the results. A more direct
formula is:

PVoa = PMT [(1 - (1 / (1 + i)n)) / i]

Where:

PVoa = Present Value of an Ordinary Annuity

PMT = Amount of each payment
i = Discount Rate Per Period
n = Number of Periods

Page 14 of 22
Example 1: What amount must you invest today at 6% compounded annually so that you can
withdraw $5,000 at the end of each year for the next 5 years?

PMT = 5,000
i = .06
n=5

PVoa = 5,000 [(1 - (1/(1 + .06)5)) / .06] = 5,000 (4.212364) = 21,061.82

Year 1 2 3 4 5
Begin 21,061.82 17,325.53 13,365.06 9,166.96 4,716.98
Interest 1,263.71 1,039.53 801.90 550.02 283.02
Withdraw -5,000 -5,000 -5,000 -5,000 -5,000
End 17,325.53 13,365.06 9,166.96 4,716.98 .00

Example 2: In practical problems, you may need to calculate both the present value of an annuity (a
stream of future periodic payments) and the present value of a single future amount:

For example, a computer dealer offers to lease a system to you for $50 per month for two years. At
the end of two years, you have the option to buy the system for $500. You will pay at the end of
each month. He will sell the same system to you for $1,200 cash. If the going interest rate is 12%,
which is the better offer?

You can treat this as the sum of two separate calculations:

1. the present value of an ordinary annuity of 24 payments at $50 per monthly period Plus
2. the present value of $500 paid as a single amount in two years.

PMT = 50 per period

i = .12 /12 = .01 Interest per period (12% annual rate / 12 payments per year)
n = 24 number of periods

PVoa = 50 [ (1 - ( 1/(1.01)24)) / .01] = 50 [(1- ( 1 / 1.26973)) /.01] = 1,062.17

+
FV = 500 Future value (the lease buy out)
i = .01 Interest per period
n = 24 Number of periods

PV = FV [ 1 / (1 + i)n ] = 500 ( 1 / 1.26973 ) = 393.78

Page 15 of 22
The present value (cost) of the lease is $1,455.95 (1,062.17 + 393.78). So if taxes are not considered,
you would be $255.95 better off paying cash right now if you have it.

Present Value of an Annuity Due (PVad)

The Present Value of an Annuity Due is identical to an ordinary annuity except that each payment
occurs at the beginning of a period rather than at the end. Since each payment occurs one period
earlier, we can calculate the present value of an ordinary annuity and then multiply the result by (1
+ i).

PVad = PVoa (1+i)

Where:

PV-ad = Present Value of an Annuity Due

PV-oa = Present Value of an Ordinary Annuity
i = Discount Rate Per Period

Example: What amount must you invest today a 6% interest rate compounded annually so that you
can withdraw $5,000 at the beginning of each year for the next 5 years?

PMT = 5,000
i = .06
n=5

PVoa = 21,061.82 (1.06) = 22,325.53

Year 1 2 3 4 5
Begin 22,325.53 18,365.06 14,166.96 9,716.98 5,000.00
Interest 1,039.53 801.90 550.02 283.02
Withdraw -5,000.00 -5,000.00 -5,000.00 -5,000.00 -5,000.00
End 18,365.06 14,166.96 9,716.98 5,000.00 .00

Combined Formula

You can also combine these formulas and the present value of a single amount formula into one.

Page 16 of 22
FUTURE VALUE
Future Value is the amount of money that an investment with a fixed, compounded interest rate will
grow to by some future date. The investment can be a single sum deposited at the beginning of the
first period, a series of equally-spaced payments (an annuity), or both. Since money has time value,
we naturally expect the future value to be greater than the present value. The difference between the
two depends on the number of compounding periods involved and the going interest rate.

Future Value Of A Single Amount

Future Value is the amount of money that an investment made today (the present value) will grow
to by some future date. Since money has time value, we naturally expect the future value to be
greater than the present value. The difference between the two depends on the number of
compounding periods involved and the going interest rate.

The relationship between the future value and present value can be expressed as:

FV = PV (1 + i)n

Where:

FV = Future Value
PV = Present Value
i = Interest Rate Per Period
n = Number of Compounding Periods

Example: You can afford to put $10,000 in a savings account today that pays 6% interest
compounded annually. How much will you have 5 years from now if you make no withdrawals?

PV = 10,000
i = .06
n=5

FV = 10,000 (1 + .06)5 = 10,000 (1.3382255776) = 13,382.26

End of Year 1 2 3 4 5
Principal 10,000.00 10,600.00 11,236.00 11,910.16 12,624.77
Interest 600.00 636.00 674.16 714.61 757.49
Total 10,600.00 11,236.00 11,910.16 12,624.77 13,382.26

Example 2: Another financial institution offers to pay 6% compounded semiannually. How much
will your $10,000 grow to in five years at this rate?

Page 17 of 22
Interest is compounded twice per year so you must divide the annual interest rate by two to obtain
a rate per period of 3%. Since there are two compounding periods per year, you must multiply the
number of years by two to obtain the total number of periods.

PV = 10,000
i = .06 / 2 = .03
n = 5 * 2 = 10

FV = 10,000 (1 + .03)10 = 10,000 (1.343916379) = 13,439.16

Future Value of Annuities

An annuity is a series of equal payments or receipts that occur at evenly spaced intervals. Leases and
rental payments are examples. The payments or receipts occur at the end of each period for an
ordinary annuity while they occur at the beginning of each period.for an annuity due.

Future Value of an Ordinary Annuity

The Future Value of an Ordinary Annuity (FVoa) is the value that a stream of expected or
promised future payments will grow to after a given number of periods at a specific compounded
interest.

The Future Value of an Ordinary Annuity could be solved by calculating the future value of each
individual payment in the series using the future value formula and then summing the results. A
more direct formula is:

FVoa = PMT [((1 + i)n - 1) / i]

Where:

FVoa = Future Value of an Ordinary Annuity

PMT = Amount of each payment
i = Interest Rate Per Period
n = Number of Periods

Example: What amount will accumulate if we deposit $5,000 at the end of each year for the next 5
years? Assume an interest of 6% compounded annually.

PV = 5,000
i = .06
n=5

FVoa = 5,000 [ (1.3382255776 - 1) /.06 ] = 5,000 (5.637092) = 28,185.46

Year 1 2 3 4 5

Page 18 of 22
 Begin 0 5,000.00 10,300.00 15,918.00 21,873.08
Interest 0 300.00 618.00 955.08 1,312.38
Deposit 5,000.00 5,000.00 5,000.00 5,000.00 5,000.00
End 5,000.00 10,300.00 15,918.00 21,873.08 28,185.46

Example 2: In practical problems, you may need to calculate both the future value of an annuity (a
stream of future periodic payments) and the future value of a single amount that you have today:

For example, you are 40 years old and have accumulated $50,000 in your savings account. You can
add $100 at the end of each month to your account which pays an interest rate of 6% per year. Will
you have enough money to retire in 20 years?

You can treat this as the sum of two separate calculations:

1. the future value of 240 monthly payments of $100 Plus

2. the future value of the $50,000 now in your account.

PMT = $100 per period

i = .06 /12 = .005 Interest per period (6% annual rate / 12 payments per year)
n = 240 periods

FVoa = 100 [ (3.3102 - 1) /.005 ] = 46,204

+
PV = 50,000 Present value (the amount you have today)
i = .005 Interest per period
n = 240 Number of periods

FV = PV (1+i)240 = 50,000 (1.005)240 = 165,510.22

After 20 years you will have accumulated $211,714.22 (46,204.00 + 165,510.22).

Future Value of an Annuity Due (FVad)

The Future Value of an Annuity Due is identical to an ordinary annuity except that each payment
occurs at the beginning of a period rather than at the end. Since each payment occurs one period
earlier, we can calculate the present value of an ordinary annuity and then multiply the result by (1
+ i).

FVad = FVoa (1+i)

Page 19 of 22
Where:

FVad = Future Value of an Annuity Due

FVoa = Future Value of an Ordinary Annuity
i = Interest Rate Per Period

Example: What amount will accumulate if we deposit $5,000 at the beginning of each year for the
next 5 years? Assume an interest of 6% compounded annually.

PV = 5,000
i = .06
n=5

FVoa = 28,185.46 (1.06) = 29,876.59

Year 1 2 3 4 5
Begin 0 5,300.00 10,918.00 16,873.08 23,185.46
Deposit 5,000.00 5,000.00 5,000.00 5,000.00 5,000.00
Interest 300.00 618.00 955.08 1,312.38 1,691.13
End 5,300.00 10,918.00 16,873.08 23,185.46 29,876.59

Combined Formula

You can also combine these formulas and the future value of a single amount formula into one.

Future Value

Definition.
This formula combines future value of a single amount and future value of an annuity.

FV =
PMT
i (
−( 1+i )n × PV +
PMT
i )
Where:

FV = Future Value
PMT = Payment
i = Interest Rate per period
n = Number of periods
PV = Present Value

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LOAN AMORTIZATION
A method for repaying a loan in equal installments. Part of each payment goes toward interest and
any remainder is used to reduce the principal. As the balance of the loan is gradually reduced, a
progressively larger portion of each payment goes toward reducing principal.

Amortization

Amortization is a method for repaying a loan in equal installments. Part of each payment goes
toward interest due for the period and the remainder is used to reduce the principal (the loan
balance). As the balance of the loan is gradually reduced, a progressively larger portion of each
payment goes toward reducing principal.

For Example, the 15 and 30 year fixed-rate mortgages common in the US are fully amortized loans.
To pay off a $100,000, 15 year, 7%, fixed-rate mortgage, a person must pay $898.83 each month for
180 months (with a small adjustment at the end to account for rounding). $583.33 of the first
payment goes toward interest and $315.50 is used to reduce principal. But by payment 179, only
$10.40 is needed for interest and $888.43 is used to reduce principal.

Amortization Schedule

An amortization schedule is a table with a row for each payment period of an amortized loan. Each
row shows the amount of the payment that is needed to pay interest, the amount that is used to reduce
principal, and the balance of the loan remaining at the end of the period.

The first and last 5 months of an amortization schedule for a $100,000, 15 year, 7%, fixed-rate
mortgage will look like this:

Amortization Schedule
Month Principal Interest Balance
1 -315.50 -583.33 99,684.51
2 -317.34 -581.49 99,367.17
3 -319.19 -579.64 99,047.98
4 -321.05 -577.78 98,726.93
5 -322.92 -575.91 98,404.01
Rows 6-175 omitted
176 -873.07 -25.76 3,543.48
177 -878.16 -20.67 2,665.32
178 -883.28 -15.55 1,782.04

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 Amortization Schedule
Month Principal Interest Balance
179 -888.43 -10.40 893.61
180 -893.62 -5.21 -0.01

Negative Amortization

Negative amortization occurs when the payment is not large enough to cover the interest due for a
period. This will cause the loan balance to increase after each payment - a situation that should
certainly be avoided. This might occur, for instance, if the rate of an adjustable-rate loan increases,
but the payment does not.

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