When presented with a finance problem (on an exam or in real life), you’re usually not told what type of problem it is or which equation to use. Here are some hints on deciding which equation to use based on the wording of the problem.
The easiest types of problem to identify are loans. Loan problems almost always include words like: “loan”, “amortize” (the fancy word for loans), “finance (a car)”, or “mortgage” (a home loan). Look for these words. If they’re there, you’re probably looking at a loan problem. To make sure, see if you’re given what your monthly (or annual) payment is, or if you’re trying to find a monthly payment.
If the problem is not a loan, the next question you want to ask is: “Am I putting money in an account and letting it sit, or am I making regular (monthly/annually/quarterly) payments or withdrawals?” If you’re letting the money sit in the account with nothing but interest changing the balance, then you’re looking at a compound interest problem. The exception would be bonds and other investments where the interest is not reinvested; in those cases you’re looking at simple interest.
If you’re making regular payments or withdrawals, the next questions is: “Am I putting money into the account, or am I pulling money out?” If you’re putting money into the account on a regular basis (monthly/annually/quarterly) then you’re looking at a basic Annuity problem. Basic annuities are when you are saving money. Usually in an annuity problem, your account starts empty, and has money in the future.
If you’re pulling money out of the account on a regular basis, then you’re looking at a Payout Annuity problem. Payout annuities are used for things like retirement income, where you start with money in your account, pull money out on a regular basis, and your account ends up empty in the future.
Remember, the most important part of answering any kind of question, money or otherwise, is first to correctly identify what the question is really asking, and to determine what approach will best allow you to solve the problem.
Try it Now 5
For each of the following scenarios, determine if it is a compound interest problem, a savings annuity problem, a payout annuity problem, or a loans problem. Then solve each problem.