# loan amortisation problem

suppose you borrowed 10000 at 10% interest to be paid semiannually over ten years…what should the semiannual rate be assumed? a) (1.1^1/2)-1 b) 5 % ideally the answer should be 1 but i am studying from kaplan and they have used b

b

accept it

Why is that ideal?

to take care of the compounding effect…if the bank is earning 10% p.a it would earn slighty less than 5% in 6 months bcos of compounding effect…

If it were earning 10% effective (compounded semiannually).

The point is that it is earning 10% _ nominal _ (compounded semiannually).

(Yes, you are expected to know the difference between effective and nominal interest rates, and be able to convert from one to the other. Alas.)

well the question did not mention compounded semi annually if it does, your answer will be right

but the question doesnt mention if its effective or nominal and usually in other type of int. rate problems (other than bonds) if the question is silent,one usually presumes it to be effective

This is simply the convention for amortizes loans. The interest rate is always stated as an APR (annual percentage rate), whis is a nominal rate. The loan problem is solved on a periodic rate. So, a 20-year, 6% inerest rate mortgage with monthly payments would be solved as a 0.5%, 240 period annuity.

Then one usually is wrong; interest rates are generally quoted as nominal rates, not effective rates.

kk…guess its different here than

Could be.

How good a guesser are you?

(I’m a notoriously horrible guesser: I tell my students that if I have to guess where in their scribbles I’m supposed to find what they think is the correct answer, I’ll aways guess wrong; they’re much better off making it unambiguously clear what they think is the answer, and leaving my guessing acumen – such as it is – out of the picture.)