audio read-through Loans and Investments (Part 1)

(This page is Part 1. Click here for Part 2.)

Need some practice with recursion and sequences first?

Loan and investment problems offer great applications of recursive sequences:

This section requires calculations that cannot reasonably be done by hand. Many calculators have the ability to work with recursive sequences. Or, there are forms on this page that you can use to do the calculations. Also, there are instructions on using WolframAlpha to work with recursive sequences.

Paying Back a Loan

Suppose you are borrowing $\,\$22{,}000\,.$ Interest is being charged at an annual rate of $\,5\%\,.$ You plan to pay back $\,\$250\,$ each month; this payment goes to both interest and principal.

(a)  Find the interest owed in the first month.
(b)   Write a recursive formula where $\,u_n\,$ gives the amount owed after $\,n\,$ months.
(c)  Then, find the amount owed after one year of payback.
(d)  Find the total principal paid in the first year.
(e)  Find the total interest paid in the first year.
(f)  Putting it all together—the brief solution.

Solution

(a) Find the interest owed in the first month

Notice that your monthly payment must be at least $\,\$91.67\,$ to cover the interest. If you were to pay exactly $\,\$91.67\,$ the first month, then your debt remains $\,\$22{,}000\,.$

If you were to pay $\,\$91.67\,$ each month for the next twenty years, you'd still owe $\,\$22{,}000\,$ at the end of those twenty years. Obviously, you want to make sure you pay more than this each month, so the amount of debt decreases.

You've decided to pay $\,\$250\,$ each month, so with this first payment you reduce your debt by $\,\$250 - \$91.67 = \$158.33\,.$ That means you now owe $\,\$22{,}000 - \$158.33 = \$21{,}841.67\,,$ which will accrue a smidgeon less interest for the next month.

Look at the pattern for the amount you owe at the end of the first month. Dollar signs and commas are suppressed, to make it a bit easier on the eyes: $$ \begin{align} &\cssId{s44}{\overset{\text{amt owed at beginning}}{\overbrace{\strut 22000}}}\cr\cr &\qquad \cssId{s45}{+ \overset{\text{interest accrued for the month}}{\overbrace{\strut (22000)(\frac{0.05}{12})}}}\cr\cr &\qquad \cssId{s46}{- \overset{\text{monthly payment}}{\overbrace{\strut \ \ 250\ \ }}}\cr\cr &\cssId{s47}{= \overset{\text{amount owed after one month}}{\overbrace{\strut 21841.67}}} \end{align} $$

Now we'll introduce the notation:

Rewriting the formula above using this notation gives: $$ \begin{align} &\cssId{s52}{\overset{\text{amt owed at beginning}}{\overbrace{\strut \ \ u_0\ \ }}}\cr\cr &\qquad \cssId{s53}{+ \overset{\text{interest accrued for the month}}{\overbrace{\strut (u_0)(\frac{0.05}{12})}}}\cr\cr &\qquad \cssId{s54}{- \overset{\text{monthly payment}}{\overbrace{\strut \ \ 250\ \ }}}\cr\cr &\cssId{s55}{= \overset{\text{amount owed after one month}}{\overbrace{\strut\ \ u_1\ \ }}} \end{align} $$

Rewrite the equation from right-to-left and factor, to get: $$ \cssId{s57}{u_1 = (1 + \frac{0.05}{12})u_0 - 250} $$

(b) Write a recursive formula where $\,u_n\,$ gives the amount owed after $\,n\,$ months

The pattern above gets applied month after month after month:

Thus, the amount owed after $\,n\,$ months is: $$\cssId{s67}{\,u_n = (1 + \frac{0.05}{12})u_{n-1} - 250\,,\ \ \text{ for } n\ge 1}$$

(c) Find the amount owed after one year of payback

Note:  For this part of the problem, you need a calculator that does recursion; or, you can use the JavaScript form below. Fill in the fields with the desired amounts. Then, click the button to compute $\,u_n\,.$ The initial (sample) values are from this current example.

The amount owed after one year (twelve months) is $\,u_{12}\,.$ From a calculator, or from the form below: $$\cssId{s77}{u_{12} = 20055.85}$$ Thus, you owe $\,\$20{,}055.85\,$ after one year.

The form below computes the amount owed after $\,n\,$ payments on a loan payback with equal monthly payments:

JavaScript Form:
The amount owed after $\,n\,$ payments on a loan payback with equal monthly payments

$u_0 =\,$ amount borrowed, in dollars:
Do not include commas or dollar sign.

Annual interest rate, $\,i\,,$ as a percent:
Do not include the percent sign.

Amount paid back each month, $\,B\,,$ in dollars:
Do not include commas or dollar sign.

Value of $\,n\,$ for which you want $\,u_n\,$:
By clicking the button below, you will calculate the amount still owed after $\,n\,$ monthly payments.


(d) Find the total principal paid in the first year

The total principal paid in the first year is: $$\cssId{s109}{\$22{,}000 - \$20{,}055.85 = \$1944.15}$$

(e) Find the total interest paid in the first year

How much money did you actually send to the bank in the first year? Twelve payments of \$250 each: $$\cssId{s113}{(12)(\$250) = \$3000}$$ Of this, you know from part (d) that $\,\$1944.15\,$ went to principal—that is, reduced your debt.

The remainder is interest—your payment for the privilege of using the bank's money for the year. Thus, the total interest paid in the first year is: $$\cssId{s117}{(12)(\$250) - \$1944.15 = \$1055.85}$$

(f) Putting it all together—the brief solution

Here's the brief solution:

Concept Practice