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SECTION 3.6 Determining the Interest Rate

A very practical application of equations (10) and (11) is determining the interest rate. In many business
transactions the true interest rate is concealed in one way or another. In order to compare different propositions
(options, investments), it is necessary to determine the true interest rate of each proposition and make the
decision based on true interest rates.

When R, n, and either S or A are given, the interest rate i may be determined approximately by linear
interpolation. For most practical purposes, linear interpolation gives sufficient accuracy and will be used
throughout this textbook.

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CALCULATION TIP:

To obtain a starting value to solve the equation by linear interpolation, we may use the formula

. To obtain a starting value to solve the equation by linear interpolation, we may use the

formula .

EXAMPLE 1Determine the interest rate j4 at which deposits of $275 at the end of every 3 months will
accumulate to $5000 at the end of 4 years.

SolutionWe have S = 5000, R = 275, n = 16, and using equation (10) we obtain:

We want to determine the rate j4 = 4i such that A starting value to solve

is or j4 = 4i = 6.41%. We suspect 6% < true j4 < 7%.

By successive trials we find two factors , one greater than 18.1818 and one less than 18.1818. The
corresponding rates j4 = 4i will provide an upper and lower bound on the unknown rate j4, which is then
approximated by a linear interpolation.

CALCULATION TIP:

The values of factors and will be rounded off to 4 decimal places, since additional places do not really
increase the accuracy. For fixed n, factors increase when i increases, whereas factors decrease when i
increases. Closer bounds on the nominal rate jm generally provide better approximations of the unknown rate jm
by linear interpolation. In this textbook we will interpolate between two nominal rates that are 1% apart.

For j4 = 6%, we calculate

For j4 = 7%, we calculate

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Now we have two rates, j4 = 6% and j4 = 7%, 1% apart, that provide upper and lower bounds for interpolation.

Arranging our data in an interpolation table we have:

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We may check the accuracy of this answer by substituting R = 275, n = 16, and into equation (10) and
calculate the accumulated value:

Linear interpolation between two nominal rates, 1% apart, gave us a very good approximation of the unknown
rate j4.

OBSERVATION:

The interest rates i and jm = mi may be computed directly using either a financial calculator or a spreadsheet.

Using a Financial Calculator to Determine i

Using the BA-II Plus calculator, we enter

Which solves for i = 1.679127782 and thus .

Using a Computer Spreadsheet to Determine i

We use Excel's financial function wizard RATE(n, -PMT, PV, FV, type), where type = 0 for an ordinary annuity
and type = 1 for an annuity due.

We type in RATE(16, -275, 0, 5000, 0)*4 and obtain .

EXAMPLE 2A used car sells for $24  000 cash or $4000 down and $3600 a month for 6 months. Determine the
interest rate, j12, if the purchaser buys the car on the instalment plan.

SolutionFor any instalment plan, the following equation of value must hold to have the cash option equivalent to
the instalment option.

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We have

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We want to determine the rate j12 = 12i such that .

A starting value to solve the equation is or j12 = 12i = 30.81%. We

By successive trials we find two factors , one greater than 5.5556 and one less than 5.5556, such that the
corresponding rates j12 are 1% apart.

For j12 = 26%, we calculate .

For j12 = 27%, we calculate .

Recall that the starting point formula provides only an approximation to the value of jm. In this example it
provided a poor approximation for the value of j12. The formula led us to suspect that 30% < true j12 < 31%.
However, at j12 = 30%, , which is too low. To raise the value of we needed to lower the
value of j12, ultimately to between 26% and 27%.

Arranging our data in an interpolation table we have:

Checking the accuracy of our answer we calculate the discounted value of the instalment plan at j12 = 26.93%

Note:Using the BA-II Plus calculator, we enter

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Which solves for i=2.244219895

and thus

Using Excel's financial function wizard = RATE(6, -3600, 20 000, 0, 0)*12 gives j12 = 26.93%.

EXAMPLE 3Deposits of $6000 are made every 6 months into a fund starting today and continuing until 10
deposits have been made. Six months after the last deposit, there is $70  630 in the fund. What nominal rate of
interest, j2, do the deposits earn?

SolutionWe have S = 70  630, R = 6000, n = 10, and an annuity due as shown on the time diagram below.

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Our equation of value is

To use the starting point formula, we need to use the ordinary annuity symbol . We recall from section 3.4,
.

Thus,

Using the starting point formula, , which gives . We suspect 5% < true j2
< 6%.

For j2 = 5%,

For j2 = 6%,

Arranging our data in an interpolation table, we have:

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To check,

Note:Using the BA-II Plus calculator (make sure you are in BGN mode since this is an annuity due):

Which gives i = 2.945037944 and thus .

Using Excel's financial function wizard = RATE(10, -6000, 0, 70630, 1)*2 gives j2 = 5.89%.

Exercise 3.6

Part A (Use linear interpolation; you can then use a financial calculator or spreadsheet to confirm your answers.)

1. Determine the interest rate j2 at which semi-annual deposits of $500 will accumulate to $6000 in 5 years.

Answers

2. What rate of interest j1 must be earned for deposits of $500 at the end of each year to accumulate to $6500
in 10 years?

3. An insurance company will pay $80  000 to a beneficiary or monthly payments of $1000 for 10 years.
What rate j12 is the insurance company using?

Answers

4. A television set sells for $1400. Sales tax of 7% is added to that. The TV may be purchased for $200 down
and monthly payments of $120 for one year. What is the interest rate j12? What is the annual effective
interest rate?

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5. You borrow $1600 from a licensed small loan company and agree to pay $150 a month for 12 months.
What nominal rate j12 is the company charging?

Answers

6. A store offers to sell a watch for $550 cash or $50 a month for 12 months. What nominal rate j12 is the
store actually charging on the instalment plan, if the first payment is made immediately?

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7. On February 1, 2005, Andreas made the first of a sequence of regular annual deposits of $1000 into an
investment account. The last deposit was made February 1, 2015. If the account earned j1 = 5%, the
balance 1 year after the last deposit would have been $27  132.38, while it would have been $28  481.20 at
j1 = 5.5%. In fact, the balance in the account one year after the last deposit was $27  500. What annual
effective rate of interest did the account earn?

Answers

Part B

The following problems are examples of situations that could arise if there were no government legislation
concerning disclosure of interest rates. In Canada, most provinces have “truth in lending” laws setting down
regulations on the disclosure of the rate of interest involved in financial transactions. It is very important to
check out all loan clauses fully.

1. The “Fly By Night” Used Car Lot uses the following to illustrate its 12% finance plan on a car paid for
over 3 years.

What is the true interest rate j12 being charged?

Answers

2. A dealer sells an article for $6000. He will allow a customer to buy it by paying $2400 down and the
balance by paying $300 a month for a year. If the customer pays cash for the item he will give a 10%
discount. Determine the interest rate j12 paid by the purchaser who uses the instalment plan described
above.

3. Goods worth $1000 are purchased using the following carrying-charge plan: A down payment of $100 is
required after which 9% of the unpaid balance is added on and the amount is then divided into 12 equal
monthly instalments. What rate of interest j12 does the plan include?

Answers

4. A finance company charges 10% “interest in advance” and allows the client to repay the loan in 12 equal
monthly payments. The monthly payment is calculated as one-12th of the total of principal and interest
(10% of principal). Determine the nominal rate compounded monthly and the annual effective rate
charged.

5. To buy a car costing $27  200 you can pay $3200 down and the balance in 36 monthly payments of $900
each. You can also borrow the money from a loan company and repay $27  200 by making quarterly
payments of $2120 over 5 years, first payment in 3 months. Compare the annual effective rates of interest
charged and determine which option is better.

Answers

6. A TV rental company uses the following illustration to prove that renting a big-screen TV at $45 a month
is cheaper than buying.
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Therefore monthly payments over 3 years at 12% are . Redo this illustration
properly at j12 = 12% and comment.

7. You are offered a loan of $10  000 with no payments for 6 months, then $600 per month for 1 year, and
$500 per month for the following year. What annual effective rate of interest does this loan charge?

Answers

8. On July 1, 2014, $8500 is deposited in Fund X. On July 1, 2014, the first of 10 consecutive semi-annual
payments of $1000 each is deposited in Fund Y. Both funds earn interest at a nominal rate j2. The balances
in the two funds are equal on July 1, 2019. Calculate j2.

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