Mathematics of Investment

MACT 3311
Chapter 3: Loan Repayment

Instructor: Roba Bairakdar, ASA

Semester: Fall 2015

Amortization Method of Loan

Repayment
The amortization method is the

distribution of payment of a loan into

multiple cash flow instalments, as
determined by an amortization schedule.
Each repayment instalment consists of both
interest and principal. When a payment is
made, it must be first applied to pay interest
due and then any remaining part of the
payment is applied to pay principal.

Exercise
Consider a loan of amount 1,000 with an
interest rate of 10% per year. Suppose that
there is a payment of 200 at the end of 1 year,
a payment of 500 at the end of 2 years, and a
final payment at the end of 3 years to
completely repay the loan.
Time t

1,000(1+10%)
= 1,100

900(1+10%)
= 990

Payment

-200

-500

-539

Outstanding
Balance

=900

=490

=0

1,000

490(1+10%)
= 539

Exercise
Consider a loan of amount , which is the
outstanding balance at time 0. Payments of
are made at time t until the payment.
The outstanding balance at time t right after
the payment is made is .

Time t

1
(1+i)

(1+i)

n-1

(1+i)

(1+i)

Payment

Outstanding
Balance

-
=

-
= =

Amortized Loan
An amortized loan of amount L made at time 0
at periodic interest i and to be repaid by n
payments of amounts 1 , 2 , at
times 1, 2, , is based on the equation
= + + +

Exercise
A borrower would like to borrow 30,000 at 8%
for 5 years, but would like to pay only 5,000
for the first two years and then catch up with
a higher payment for the final three years.
What is the payment for the final 3 years?
Solution:
30,000 = 5,0002| + 2 3|
30,000 = 5,000 1.783 + 0.857 2.577
= 9,542.52
6

Components of a general
Amortized Loan
Loan Amount L:
Loan amount L at periodic interest i and to be
repaid by n payments of amounts
1 , 2 , at the end of n successive
periods.
Outstanding Balance :
is the amount owed on the loan just after
the payment was made.
= and =
7

Components of a general
Amortized Loan
Interest Due :
is the interest on the outstanding balance
since the previous payment was made.
=
Principal Repaid :
is the part of the payment that is
applied toward repaying the loan principal
amount.
=
8

Outstanding Balance Calculation

Outstanding Balance :
=
=
= +

Amortization Schedule

10

Payment

Interest Due

Principal Repaid

Outstanding Balance

__

__

__

1,000

200

1,000 x 10%
= 100

200 100 = 100

1,000 100 = 900

500

900 x 10% =
90

500 90 = 410

900 410 = 490

539

490 x 10% =
49

539 49 = 490

490 490 = 0

Amortization Schedule
t

Payment

Interest Due

Principal Repaid

Outstanding Balance

__

__

__

= 0

1 = 0 x

1 = 1 1

1 = 0 1

2 = 1 x

2 = 2 2

2 = 1 2

.
.
.

t
.
.
.

11

.
.
.

.
.
.

.
.
.

= 1 x
.
.
.

= 1 x

.
.
.

=
.
.
.

.
.
.

= 1
.
.
.

= 1 = 0

Prospective Method
The loan balance after a payment is made is
the present value of the remaining payments
at the time of payment.

Time t

t+1

= + + +
12

n-1

Exercise
A borrower would like to borrow 30,000 at 8%
for 5 years. He would like to repay his loan by
making level annual payments at the end of
each year. Calculate the outstanding balance
after the third payment was made using the
prospective method.
Solution:
30,000 = 5|
= 7,513.69
3 = 7,513.69 + 2 = 13,398.9
13

Retrospective Method
The loan balance after a payment is made is
the amount of the loan accumulated to time t,
minus the accumulated value of all payments
to time t, up to and including .
Time t

t-1

( + )

( + )

( + )

= ( + ) +

Exercise
A borrower would like to borrow 30,000 at 8% for
5 years. He would like to repay his loan by making
level annual payments at the end of each year.
Calculate the outstanding balance after the third
payment was made using the retrospective
method.
Solution:
30,000 = 5|
= 7,513.69
3
= 30,000(1 + )3 7,513.69 1 +
7,513.69 = 13,398.9
15

7,513.69 1 +

Exercise
A loan at 10% annually has an initial payment of 100, and 9
further payments. The payment amount increases by 2%
each year. Find the loan balance immediately after the
fourth payment.
Solutions:
The payments are 100, 100 1.02 , , 100(1.02)9 .
Immediately after the fourth payments, the remaining
payments are 100(1.02)4 , , 100(1.02)9 .
100(1.02)4
100 1.02 9
4 =
+ +
1.1
1.16
6
1.02
100 1.02 4
1.02
1.02 5
100 1.02 4 1 1.1
=
1+
+ +
=
1.02
1.1
1.1
1.1
1.1
1
1.1
= 492.93
16

Exercise
A 30-year monthly payment mortgage loan for
250,000 is offered at a rate of 6%. The
borrower would like to have graduated
payments where the first years monthly
payment if P, the second years monthly
payment is P+100 and all subsequent
payments are P+200. Find the
a. Initial Payment P
b. Balance at the end of one year

17

Exercise contd
a. Using the equation of value

250,000 = 360|0.005 + 100 12 348|0.005

+100 24 336|0.005
= 1,319.37
b. Using the prospective method

12 = ( + 100)348|0.005 +100 12 336|0.005

= 249,144

18

Exercise
You have a 30,000 loan at 8% annually for 5
years. You agree to pay off the principal in
instalments of 6,000 per year, and to pay
interest on the outstanding balance each year.
What is the interest due in the 4th payment?
Solution:
3 = 30,000 3 6000 = 12,000
4 = x 3 = 0.08 x 12,000 = 960

19

Exercise
A loan at 10% annually has an initial payment
of 100, and 9 further payments. The payment
amount increases by 10 each year. Find the
loan balance immediately after the fourth
payment.
Solution:
4 = 1406|10% + 10()5|10% = 706.57

20

Level Payment Loan

Prospective / Retrospective Method
For a level payment loan of n periods with a
payment PMT, the outstanding balance at time
t can be expressed is

= | = ( + ) |

21

Level Payment Loan Amortization

Schedule
t

Payment Interest Due

Principal
Repaid

Outstanding Balance

__

__

__

= 0 = |

=1

1 = |
= 1

1 = 1 1 =

1 = 0 1 = |
= 1|

=1

2 = 1|
= 1 1

2 = 2 2
= 1

2 = 1 2
= 1| 1 = 2|

.
.
.

.
.
.

.
.
.

.
.
.

=1

.
.
.

.
.
.

.
.
.

=1

1 = 1|
= 1

= (1)|
= 1 (1)

=
= (1)
.
.
.

= =

.
.
.

= 1
= (1)| (1) = |
.
.
.

= 1 =
= 1| = 0

Level Payment Loan Amortization

Components
Interest paid in payment :
= (

Total interest paid:

+ + +
=

Principal paid :

= |

= ()
+ = ( + )

Total principal paid:

=

23

Exercise
A 30-year monthly payment mortgage loan for
250,000 is offered at a nominal rate of 6%
convertible monthly. Find the
a. Monthly Payment
b. The total principal and interest that would
be paid on the loan over 30 years
c. The balance in 5 years
d. The principal and interest paid over the
first 5 years

24

Exercise contd
Solution:
a.
250,000 = 360|0.005
= 1,498
b.

Total principal = amount of the loan = 250,000

Total Interest = 360 1,498 250,000 = 289,596

c.

The balance in 5 years

60 = 1,498300|0.005 = 232,635

c.

The principal paid over 5 years =

250,000 232,635 = 17,364
The total interest paid in 5 years =
60 1,498 17,364 = 72,569

25

Exercise
A borrower would like to borrow 30,000 at 8%
for 5 years. He would like to repay his loan by
making level annual payments at the end of
each year. Calculate the level payment.
Solution:
30,000 = 5|
30,000 = 3.99271
= 7,513.69

26

Exercise
Following on the previous example, what is the
principal paid in the 4th payment?
Solution:
= (1) = 7,513.69 5(41) = 6,441.78

27

Exercise
For an 8% level payment loan, the amount of
principal in the second payment is 5,522.79.
Find the amount of principal in the 4th
payment.
Solution:
+ = (1 + )
4 = (1 + )2 2 = (1 + 0.08)2 5522.79
= 6,441.78

28

Exercise (SOA)
A loan of 1,000 at a nominal rate of 12%
convertible monthly is to be repaid by six
monthly payments with the first payment due
at the end of 1 month.
The first three payments are x each, and the
final three payments are 3x each.

Determine the sum of the principal repaid in

the third payment and the interest in the fifth
payment.
29

Exercise (SOA) contd

1000 = 3|1% + 3 3 3|1% By solving for x, = 86.92
Principal repaid in the third payment = 3 = 2
3
2 = + 33|1% = 845.4 (prospectively)
2 = 1000(1.01)2 2|1% = 845.4 (retrospectively)
3 = 33|1% = 766.9 (prospectively)
3 = 1000(1.01)3 3|1% = 766.9 (retrospectively)
Principal repaid in the third payment = 845.4
766.9 = 78.6
30

Exercise (SOA) contd

Interest paid in the fifth payment = 5 = 4 .
4 = 32|1% = 513.8 (prospectively)
5 = 4 . = 513.8 (1%) = 5.138
3 + 5 = 83.738

31

Sinking Fund Repayment of a

Loan
When you use a sinking fund, you only pay
the lender the interest at his stated rate i on
the loan each period. In addition, you make
level deposits to an account called a sinking
fund that earns interest at a rate j.
The goal is to make a deposit into the sinking
fund that will cause the fund to grow to the
amount of the loan at the end of the loan term

32

Exercise
A 100,000 annual payment loan is made for a
term of 10 years at 10% interest. The lender
agreed to take only payments of interest until
the end of year 10 when the 100,000 must be
repaid. The borrower will make level annual
year-end payments to a sinking fund earning
8%.
Find the
a. Sinking fund deposit
b. Total annual loan payment
c. Balance in the sinking fund at time 3.
33

Exercise contd
Solution:
a. Sinking Fund annual deposit = K, where

100,000 = 10|0.08
= 6,903
b. Total annual loan payment = 6,903

+ 100,000 10% = 16,903

c. Balance at time 3 = 6,9033|0.08 = 22,410
34

Exercise - Sinking Fund

compared to Amortization
A borrower would like to borrow 1,000 at 10% for
10 years. What is the level annual payment using
the amortization method?
Assume the lender agreed to take only payments
of interest until the end of year 10 when the 1,000
must be repaid. The borrower will make level
annual year-end payments to a sinking fund.
What is the level annual payment if the sinking
fund earns 8%, 10% or 12%?

35

Exercise contd
Using the amortization method, the level
1,000
annual payment is
= 162.75
10|10%

Using the sinking fund method,

Annual Interest SF Interest SF Deposit
payment
Rate

36

Total
annual
payment

100010% = 100

8%

1,000
= 69.03
10|8%

169.03

100010% = 100

10%

1,000
= 62.75
10|10%

162.75

100010% = 100

12%

1,000
= 56.98
10|12%

156.98

Sinking Fund components

Total payment each period =

+ . = + .
|
Balance in the Sinking Fund at time k =
= |
Principal paid in the kth payment=
= | |
= ( + )
Net interest in the kth payment=
=
. .

or
37

=
+ . +

Exercise
For a sinking fund loan, SFD = 6902.95 and
the interest rate for the sinking fund is 8%.
Find the principal paid in the 4th payment?
Solution:
= (1 + )1
6902.95(1 + 8%)41 = 8695.73

38

Exercise
For a sinking fund loan, SFD = 5310.76 and
the amount of principal in the third payment
is 5967.17. What is the interest rate?
Solution:
= (1 + )1
5,916.17 = 5,310.76(1 + )31
= 0.06

39

Capitalization of interest and

negative amortization
It is possible that during repayment of a loan
by the amortization method, the payment is
not large enough to cover the interest due
( < ).
Capitalization of interest and negative
amortization occur when the payment made is
less than the interest on the loan. In other
words, the outstanding balance increases by
the amount of unpaid interest.
40

Exercise
A borrower would like to borrow 30,000 at 8% for
5 years, but would like to pay only 2,000 for the
first two years and then catch up with a higher
payment for the final three years. What is the
payment for the final 3 years?
Illustrate the payments by using the amortization
schedule.
Solution:
2 = 30,000(1.08)2 2,000 1.08 2,000 = 30,832
30,832 = 3|0.08
= 11,964
41

Exercise contd
t

Payment Interest Due

Principal
Repaid

Outstanding Balance

__

__

__

30,000

2,000

2,400

400

30,400

2,000

2,432

432

30,832

11,964

2,466.56

9,479.29

21,334.71

11,964

1,706.78

10,257.07

11,077.64

11,964

886.21

11,077.64

42

Exercise
Referring to the previous question, find the
principal paid, interest required and the
balance in year 1 if the initial payment were
1,500 instead of 2,000.
Solution:
Interest = 2,400
Principal = -900
Balance = 30,900

43