Series of payments

By this stage, you know how to do calculations such as `If I want R 1000 in three years' time, how much do I need to invest now at ?' What if we e tend this as follows! "If I want to draw R 1000 ne t year, R 1000 the ne t year and R 1000 after three years, how much do I need to initially #ut into a $ank account earning #%a% to $e a$le to afford to $e a$le to do this?& 'he o$vious way of working that out is to work out how much you need now to afford the #ayments individually and sum them% We'll work out how much is needed now to afford the #ayment of R 1000 in a year R R R , the R amount needed now for the following year's R R and the amount needed now for the R 1000 after three years

R % (dding these together gives you the amount needed to afford all three #ayments and you get R % )o, if you #ut R into a $ank account now, you will $e a$le to draw out R 1000 in a year, R 1000 a year after that, and R 1000 a year after that * and your $ank account $alance will decrease to R0% +ou would have had e actly the right amount of money to do that ,o$viously-.% +ou can check this as follows!

(mount at 'ime 0 ,i%e% /ow. (mount at 'ime 1 ,i%e% a year later. 0 R (mount after withdrawing R 1000 0 R (mount at 'ime 1 ,i%e% a year later. 0 R (mount after withdrawing R 100 0 0 R (mount at 'ime 3 ,i%e% a year later. 0 R (mount after withdrawing R 1000 0 R 'a$le 1 R 1000 R 1000 R 1000

0R 0R 0R 0R 0 R 202,02 0 R 1000 0 R0

4erfect- 5f course, for only three years, that was not too $ad% But what if I asked you how much you needed to #ut into a $ank account now, to $e a$le to afford R 100 a month for the ne t 16 years% If you used the a$ove a##roach you would still get the right answer, $ut it would take you weeks'here is * I'm sure you guessed * an easier way- 'his section will focus on descri$ing how to work with!

annuities * a fi ed sum #aya$le each year or each month, either to #rovide a #re* determined sum at the end of a num$er of years or months ,referred to as a future value annuity. or a fi ed amount #aid each year or each month to re#ay ,amortise. a loan ,referred to as a #resent value annuity.% bond repayments * a fi ed sum #aya$le at regular intervals to #ay off a loan% 'his is an e am#le of a #resent value annuity% sinking funds * an accounting term for cash set aside for a #articular #ur#ose and invested so that the correct amount of money will $e availa$le when it is needed% 'his is an e am#le of a future value annuity%

)e7uences and series

Before we #rogress, you need to go $ack and read 8ha#ter ,Reference. ,from 4age ,Reference.. to revise se7uences and series% In summary, if you have a series of n terms in total which looks like this!

,1. this can $e sim#lified as!

,1.

4resent values of a series of #ayments

)o having reviewed the mathematics of se7uences and series, you might $e wondering how this is meant to have any #ractical #ur#ose- 9iven that we are in the finance section, you would $e right to guess that there must $e some financial use to all this% :ere is an e am#le which ha##ens in many #eo#le's lives * so you know you are learning something #ractical%

;et us say you would like to $uy a #ro#erty for R 300 000, so you go to the $ank to a##ly for a mortgage $ond% 'he $ank wants it to $e re#aid $y annually #ayments for the ne t 10 years, starting at end of this year% 'hey will charge you interest #er annum% (t the end of the 10 years the $ank would have received $ack the total amount you $orrowed together with all the interest they have earned from lending you the money% +ou would o$viously want to work out what the annual re#ayment is going to $e;et < $e the annual re#ayment, i is the interest rate, and = is the amount of the mortgage $ond you will $e taking out% 'ime lines are #articularly useful tools for visualising the series of #ayments for calculations, and we can re#resent these #ayments on a time line as! Figure 1: 'ime line for an annuity ,in arrears. of < for n #eriods% 'he #resent value of all the #ayments ,which includes interest. must e7uate to the ,#resent. value of the mortgage loan amount% =athematically, you can write this as!

,3. 'he #ainful way of solving this #ro$lem would $e to do the calculation for each of the terms a$ove * which is 10 different calculations% /ot only would you #ro$a$ly get $ored along the way, $ut you are also likely to make a mistake% /aturally, there is a sim#ler way of doing this- +ou can rewrite the a$ove e7uation as follows!

,>. 5f course, you do not have to use the method of su$stitution to solve this% We ?ust find this a useful method $ecause you can get rid of the negative e #onents * which can $e 7uite confusing- (s an e ercise * to show you are a real financial whi@@ * try to solve this without su$stitution% It is actually 7uite easy% /ow, the item in s7uare $rackets is the sum of a geometric se7uence, as discussion in section ,Reference.% 'his can $e re*written as follows, using what we know from 8ha#ter ,Reference. of this te t $ook!

,6. /ote that we took out a common factor of v $efore using the formula for the geometric se7uence% )o we can write!

,A. 'his can $e re*written!

,B. )o, this formula is useful if you know the amount of the mortgage $ond you need and want to work out the re#ayment, or if you know how $ig a re#ayment you can afford and want to see what #ro#erty you can $uy% Cor e am#le, if I want to $uy a house for R 300 000 over 10 years, and the $ank is going to charge me #er annum on the outstanding $alance, then the annual re#ayment is!

,D. 'his means, each year for the ne t 10 years, I need to #ay the $ank R year $efore I have #aid off the mortgage $ond% #er

5n the other hand, if I know I will have only R 30 000 #er year to re#ay my $ond, then how $ig a house can I $uy? 'hat is easy%

,2. )o, for R 30 000 a year for 10 years, I can afford to $uy a house of R 1DB D00 ,rounded to the nearest hundred.% 'he $ad news is that R 1DB D00 does not come close to the R 300 000 you wanted to #ay'he good news is that you do not have to memorise this formula% In fact , when you answer 7uestions like this in an e am, you will $e e #ected to start from the $eginning * writing out the o#ening e7uation in full, showing that it is the sum of a geometric se7uence, deriving the answer, and then coming u# with the correct numerical answer%

Example 1: =onthly mortgage re#ayments

Euestion )am is looking to $uy his first flat, and has R 16 000 in cash savings which he will use as a de#osit% :e has viewed a flat which is on the market for R 160 000, and he would like to work out how much the monthly re#ayments would $e% :e will $e taking out a 30 year mortgage with monthly re#ayments% 'he annual interest rate is % (nswer
Fetermine what is given and what is needed

'he following is given!

Fe#osit amount 0 R 16 000 4rice of flat 0 R 160 000 interest rate,

We are re7uired to find the monthly re#ayment for a 30*year mortgage%

Fetermine how to a##roach the #ro$lem

We know that!

,10. In order to use this e7uation, we need to calculate =, the amount of the mortgage $ond, which is the #urchase #rice of #ro#erty less the de#osit which )am #ays u#front%

,11. /ow $ecause we are considering monthly re#ayments, $ut we have $een given an annual interest rate, we need to convert this to a monthly interest rate, on this, go $ack and revise )ection ,Reference.%. % ,If you are not clear

,11. We know that the mortgage $ond is for 30 years, which e7uates to 3A0 months%
)olve the #ro$lem

/ow it is easy, we can ?ust #lug the num$ers in the formula, $ut do not forget that you can always deduce the formula from first #rinci#les as well-

,13.
Write the final answer

'hat means that to $uy a flat for R 160 000, after )am #ays a R 16 000 de#osit, he will make re#ayments to the $ank each month for the ne t 30 years e7ual to R %

Example 2: =onthly mortgage re#ayments

Euestion +ou are considering #urchasing a flat for R 100 000 and the $ank's mortgage rate is currently #er annum #aya$le monthly% +ou have savings of R 10 000 which you intend to use for a de#osit% :ow much would your monthly mortgage #ayment $e if you were considering a mortgage over 10 years% (nswer
Fetermine what is given and what is re7uired

'he following is given!

Fe#osit amount 0 R 10 000 4rice of flat 0 R 100 000 Interest rate,

We are re7uired to find the monthly re#ayment for a 10*year mortgage%

Fetermine how to a##roach the #ro$lem

We are considering monthly mortgage re#ayments, so it makes sense to use months as our time #eriod% 'he interest rate was 7uoted as #er annum #aya$le monthly, which means that the

monthly effective rate #er month% 5nce we have converted 10 years into 1>0 months, we are ready to do the calculationsCirst we need to calculate =, the amount of the mortgage $ond, which is the #urchase #rice of #ro#erty minus the de#osit which )am #ays u#*front%

,1>. 'he #resent value of our mortgage #ayments < ,which includes interest., must e7uate to the #resent mortgage amount

,16. But it is clearly much easier to use our formula than work out 1>0 factors and add them all u#)olve the #ro$lem

,1A.
Write the final answer

)o to re#ay a R 120 000 mortgage over 10 years, at cost you R #er month for 1>0 months%

interest #aya$le monthly, will

)how me the money

/ow that you've done the calculations for the worked e am#le and know what the monthly re#ayments are, you can work out some sur#rising figures% Cor e am#le, R #er month for 1>0 months makes for a total of R , R .% 'hat is more than dou$le the amount that you $orrowed- 'his seems like a lot% :owever, now that you've studied the effects of time ,and interest. on money, you should know that this amount is somewhat meaningless% 'he value of money is de#endant on its timing% /onetheless, you might not $e #articularly ha##y to sit $ack for 10 years making your R mortgage #ayment every month knowing that half the money you are #aying are going toward interest% But there is a way to avoid those heavy interest charges% It can $e done for less than R300 e tra every month% )o our #ayment is now R 1000% 'he interest rate is still #er annum #aya$le monthly ,0,B6G #er month., and our #rinci#al amount $orrowed is R 120 000% =aking this higher re#ayment amount every month, how long will it take to #ay off the mortgage?

'he #resent value of the stream of #ayments must $e e7ual to R 120 000 ,the #resent value of the $orrowed amount.% )o we need to solve for n in!

,1B. )o the mortgage will $e com#letely re#aid in less than 1> years, and you would have made a total #ayment of R R 333 A00% 8an you see what is ha##ened? =aking regular #ayments of R 1000 instead of the re7uired R , you will have saved R , R R 333 A00. in interest, and yet you have only #aid an additional amount of R 120,61 for 1AA,D months, or R % +ou surely know $y now that the difference $etween the additional R that you have #aid and the R interest that you have saved is attri$uta$le to, yes, you have got it, com#ound interest-

Cuture value of a series of #ayments

In the same way that when we have a single #ayment, we can calculate a #resent value or a future value * we can also do that when we have a series of #ayments% In the a$ove section, we had a few #ayments, and we wanted to know what they are worth now * so we calculated #resent values% But the other #ossi$le situation is that we want to look at the future value of a series of #ayments% =ay$e you want to save u# for a car, which will cost R >6 000 * and you would like to $uy it in 1 years time% +ou have a savings account which #ays interest of #er annum% +ou need to work out how much to #ut into your $ank account now, and then again each month for 1 years, until you are ready to $uy the car% 8an you see the difference $etween this e am#le and the ones at the start of the cha#ter where we were only making a single #ayment into the $ank account * whereas now we are making a series of #ayments into the same account? 'his is a sinking fund%

)o, using our usual notation, let us write out the answer% =ake sure you agree how we come u# with this% Because we are making monthly #ayments, everything needs to $e in months% )o let ( $e the closing $alance you need to $uy a car, 4 is how much you need to #ay into the $ank account each month, and is the monthly interest rate% ,8areful * $ecause is the annual interest rate, so we will need to work out later what the monthly interest rate is-.

,1D. :ere are some im#ortant #oints to remem$er when deriving this formula! 1% We are calculating future values, so in this e am#le we use and not

% 8heck $ack to the start of the cha#ter if this is not o$vious to you $y now% 1% If you draw a timeline you will see that the time $etween the first #ayment and when you $uy the car is 1> months, which is why we use 1> in the first e #onent% 3% (gain, looking at the timeline, you can see that the 1>th #ayment is $eing made one month $efore you $uy the car * which is why the last e #onent is a 1% >% (lways check that you have got the right num$er of #ayments in the e7uation% 8heck right now that you agree that there are 1> terms in the formula a$ove% )o, now that we have the right starting #oint, let us sim#lify this e7uation!

,12. /ote that this time < has a #ositive e #onent not a negative e #onent, $ecause we are doing future values% 'his is not a rule you have to memorise * you can see from the e7uation what the o$vious choice of < should $e% ;et us re*order the terms!

,10. 'his is ?ust another sum of a geometric se7uence, which as you know can $e sim#lified as!

,11. )o if we want to use our num$ers, we know that R >6 000, looking at monthly #ayments, so there are 1> months involved. and annum% ,$ecause we are #er

BH' ,and it is a $ig $ut. we need a monthly interest rate% Fo not forget that the trick is to kee# the time #eriods and the interest rates in the same units * so if we have monthly #ayments, make sure you use a monthly interest rate- Hsing the formula from 9rade 11, we know that % )o we can show that % 'herefore,

,11. 'his means you need to invest R 1AA 1AB each month into that $ank account to $e a$le to #ay for your car in 1 years time%

Exercise 1:
4ro$lem 1! +ou have taken out a mortgage $ond for R DB6 000 to $uy a flat% 'he $ond is for 30 years and the interest rate is #er annum #aya$le monthly% 1% What is the monthly re#ayment on the $ond? 1% :ow much interest will $e #aid in total over the 30 years? 4ro$lem 1! :ow much money must $e invested now to o$tain regular annuity #ayments of R 6600 #er month for five years? 'he money is invested at 11,1G #%a%, com#ounded monthly% ,(nswer to the nearest hundred rand%. (nswer 1! a.

$.

(nswer 1!