Loans

Loans
 Loan
• Loan is an arrangement in which a lender gives money or property to
a borrower, and the borrower agrees to return the property or repay
the money, usually along with interest, at some future point(s) in time.

• Various methods of repaying a loan are possible.

• We will consider two of them:

• The amortization method

• the sinking fund method.

The amortization method
• the borrower makes installment payments to the lender.

• these payments are at a regularly spaced periodic intervals;

• the progressive reduction of the amount owed is described as

the amortization of the loan.

• E.g. car loan, home mortgage repayment.

 Finding the Loan Balance
• When using the amortization method, the payments form an annuity
whose present value is equal to the original amount of the loan.

• We want to determine the unpaid balance (or the outstanding loan

balance/unpaid principal) at any time after the inception of the loan.

• There are two approaches to find the outstanding balance:

• the prospective method

• the retrospective method.

• Prospective method:

• outstanding loan balance at any point in time is equal to the

present value at that date of the remaining payments.

• Retrospective method:

• outstanding loan balance at any point in time is equal to the original

amount of the loan accumulated to that date less the accumulated
value at that date of all payments previously made.
• the two approaches are equivalent. At the time of inception of the loan we have
the following equality
Present Value of All Payments = Amount of Loan
• Accumulate each side of the equation to the date at which the outstanding loan
balance is desired, obtaining
Current Value of Payments = Accumulated Value of Loan Amount
• But payments can be divided into past and future payments giving
Accumulated Value of Past Payments + Present Value of Future Payments
= Accumulated Value of Loan Amount
Present Value of Future Payments
= Accumulated Value of Loan Amount
− Accumulated Value of Past Payments
 𝑝
• Let𝐵𝑡 and 𝐵𝑡𝑟 denote the outstanding loan balances at time 𝑡 using the
prospective and retrospective methods respectively.
• We denote the initial loan by 𝐿.
• The loan is repaid by level payments of 𝑃 for 𝑛 periods at a periodic interest of 𝑖.
𝐿
𝑃=
𝑎𝑛|

• For 0 < 𝑡 < 𝑛, the outstanding loan balance at time 𝑡 computed after making the
𝑡th payment by the prospective method is
𝑝
𝐵𝑡 = 𝑃𝑎𝑛−𝑡|

• By the retrospective method

𝐵𝑡𝑟 = 𝐿 1 + 𝑖 𝑡
− 𝑃𝑠𝑡|ഥ
 Example 37.4

A loan of 1,000 is being repaid with quarterly

payments at the end of each quarter for 5
years, at 6% convertible quarterly. Find the
outstanding loan balance at the end of the 2nd
year.
 Example 37.2
A loan is being repaid with 16 quarterly payments, where the
first 8 payments are each $200 and the last 8 payments are
each $400. If the nominal rate of interest convertible quarterly
is 10%, use both the prospective method and the retrospective
method to find the outstanding loan balance immediately after
the first six payments are made.
 Example 37.1

A loan is being repaid with 25 annual payments of 300

each. With the 10th payment, the borrower pays an extra
1,000, and then repays the balance over 10 years with a
revised annual payment. The effective rate of interest is
8%. Calculate the amount of the revised annual payment.
 Example 37.3 >> Practice Problems Set 37

Megan is buying a car for 30,000 using a 60-month car loan

with an interest rate of 9% compounded monthly. For the first
two years, Megan makes the required payment. Beginning with
the first payment in the third year, Megan begins paying twice
the required payment. Megan will completely pay off her loan by
making a smaller final payment. Determine the total number of
payments that Megan will make.
 Amortization Schedules
When a loan is being repaid with the amortization method,
each payment is partially a repayment of principal and partially
a payment of interest.

An amortization schedule is a table which shows the division of

each payment into principal and interest, together with the
outstanding loan balance after each payment is made.
Consider a loan of 𝑎𝑛| at interest rate 𝑖 per period being repaid with payments of 1 at
the end of each period for 𝑛 periods.

At the end of period 1, the interest paid is 𝑖𝑎𝑛| = 1 − 𝑣 𝑛 so that the principal repaid is

𝑣 𝑛 , and the outstanding loan balance is 𝑎𝑛| − 𝑣 𝑛 = 𝑎𝑛−1| .

At the end of the second period, the interest paid is 𝑖𝑎𝑛−1| = 1 − 𝑣 𝑛−1 so that the

principal repaid is 𝑣 𝑛−1 , and the outstanding loan balance is 𝑎𝑛−1| − 𝑣 𝑛−1 = 𝑎𝑛−2| .

Continuing this process, at the end of period 𝑘, the interest paid is 𝑖𝑎𝑛−𝑘+1| = 1 −

𝑣 𝑛−𝑘+1 and the principal repaid is 𝑣 𝑛−𝑘+1 . The outstanding loan balance is 𝑎𝑛−𝑘+1| −
𝑝
𝑣 𝑛−𝑘+1 = 𝑎𝑛−𝑘| = 𝐵𝑘 .
• 𝐼𝑡 : interest paid at the end of year 𝑡
• 𝑃𝑡 : principal repaid at the end of year 𝑡
• 𝐵𝑡 : outstanding loan balance at the end of year 𝑡 (just after the loan payment is made)
• 𝑅𝑡 : loan payment at the end of year 𝑡
Period Payment Interest paid Principal repaid Outstanding loan balance
𝒕 𝑹𝒕 𝑰𝒕 = 𝒊𝑩𝒕−𝟏 𝑷𝒕 = 𝑹𝒕 − 𝑰𝒕 𝑩𝐭 = 𝑩𝒕−𝟏 − 𝑷𝒕
0 0 0 0 𝑎𝑛|
ഥ
𝑛 𝑛
1 1 𝑖𝑎𝑛|
ഥ =1−𝑣 𝑣𝑛 𝑎𝑛|
ഥ − 𝑣 = 𝑎𝑛−1|

2 1 𝑖𝑎𝑛−1| = 1 − 𝑣 𝑛−1 𝑣 𝑛−1 𝑎𝑛−1| − 𝑣 𝑛−1 = 𝑎𝑛−2|

⋮ ⋮ ⋮ ⋮ ⋮
𝑡 1 𝑖𝑎𝑛−𝑡+1| = 1 − 𝑣 𝑛−𝑡+1 𝑣 𝑛−𝑡+1 𝑎𝑛−𝑡+1| − 𝑣 𝑛−𝑡+1 = 𝑎𝑛−𝑡|
⋮ ⋮ ⋮ ⋮ ⋮
𝑛−1 1 𝑖𝑎2|
ഥ =1−𝑣
2 𝑣2 𝑎2| 2
ഥ − 𝑣 = 𝑎1|
ഥ

𝑛 1 𝑖𝑎1|
ഥ =1−𝑣 𝑣 𝑎1|
ഥ −𝑣 =0
Period Payment Interest paid Principal repaid Outstanding loan balance
𝒕 𝑹𝒕 𝑰𝒕 = 𝒊𝑩𝒕−𝟏 𝑷𝒕 = 𝑹𝒕 − 𝑰𝒕 𝑩𝐭 = 𝑩𝒕−𝟏 − 𝑷𝒕
0 0 0 0 𝑎𝑛|
1 1 𝑖𝑎𝑛| = 1 − 𝑣 𝑛 𝑣𝑛 𝑎𝑛| − 𝑣 𝑛 = 𝑎𝑛−1|
2 1 𝑖𝑎𝑛−1| = 1 − 𝑣 𝑛−1 𝑣 𝑛−1 𝑎𝑛−1| − 𝑣 𝑛−1 = 𝑎𝑛−2|
⋮ ⋮ ⋮ ⋮ ⋮
𝑡 1 𝑖𝑎𝑛−𝑡+1| = 1 − 𝑣 𝑛−𝑡+1 𝑣 𝑛−𝑡+1 𝑎𝑛−𝑡+1| − 𝑣 𝑛−𝑡+1 = 𝑎𝑛−𝑡|
⋮ ⋮ ⋮ ⋮ ⋮
𝑛−1 1 𝑖𝑎2|
ഥ =1−𝑣
2 𝑣2 𝑎2| 2
ഥ − 𝑣 = 𝑎1|
ഥ

𝑛 1 𝑖𝑎1|
ഥ =1−𝑣 𝑣 𝑎1|
ഥ −𝑣 =0

Total 𝑛 𝑛 − 𝑎𝑛| 𝑎𝑛|

• the outstanding loan balance agrees with that obtained by the prospective method

• the sum of the principal repayments equals to the original amount of the loan.

• the sum of principal repayments is a geometric progression with common ratio 1 + 𝑖

• the sum of interest payments is equal to the difference between the sum of the total payments and the sum of the
principal repayments.
 Example 38.1
Create an amortization schedule for a loan of $1,000 repaid over four years if
the annual effective rate of interest is 8%.
$1,000.00
$900.00
$800.00
$700.00
$600.00
$500.00
$400.00
$300.00
$200.00
$100.00
$0.00
1 2 3 4 5
Principle Interest Balance
 Example 38.2
Create an amortization schedule for a loan of $10,000 repaid
over three years if the annual effective rate of interest is 7%.

In practice, there will be rounding errors as the table is generated line by line, and
the last line may not lead to a zero balance. Standard practice is to adjust the last
payment so that it is exactly equal to the amount of interest for the final period
plus the outstanding loan balance at the beginning of the final period, in order to
bring the outstanding loan balance to 0.
 Example 38.5
A $5,000 loan is being repaid by payments of $X at the end of each half
year for as long as necessary until a smaller final payment is made. The
nominal rate of interest convertible semiannually is 14%.

a) If X = $400 find the amount of principal and the interest in the sixth
payment.

b) If X = $350; find the principal in the sixth payment, and interpret this.
>> Practice Problems Set 38
The sinking fund method
• the loan will be repaid by a single lump sum payment at
the end of the term of the loan.

• The borrower pays interest on the loan in installments

over this period.
Sinking Fund
• a borrower can accumulate a fund which will exactly repay the
loan in one lump sum at the end of a specified period of time.
This fund is called a sinking fund.

• Because the balance in the sinking fund could be applied

against the loan at any point, the net amount of the loan is
equal to the original amount of the loan minus the sinking
fund balance.
 Sinking Fund Method ≡ Amortization method
• If the rate of interest paid on the loan equals the rate of interest earned on the sinking fund, then
the amortization method and the sinking fund method are equivalent.

• Suppose that the effective annual rate on the loan is 𝑖, and the sinking fund earns the same rate.
Suppose that the amount of the loan is 1, and the loan term is 𝑛 periods. With the amortization

1
method, the payment at the end of each period is . With the sinking fund method, to
𝑎𝑛|

1
accumulate the amount of 1 in the sinking fund, the borrower deposits of the end of each
𝑠𝑛|

year for 𝑛 years. At the same moment the borrower also pays 𝑖 per period to the lender. That is,

1 1 1
payments of size 𝑖 (interest) plus payments of size are required. = +1
𝑠𝑛| 𝑎𝑛| 𝑠𝑛|
Example 39.1

Create a sinking fund schedule for a loan

of $1000 repaid over four years if the
annual effective rate of interest is 8%.
Notice that the amount in the sinking fund after the 𝑡th payment is found by multiplying the
sinking fund deposit by 𝑠𝑡|𝑗
ഥ where 𝑗 is the sinking fund rate of interest.

1) For each period, Interest paid + Sinking Fund deposit = Payment amount

2) For each period, Interest paid(SF) − Interest earned on sinking fund = Interest
paid(A)

3) For each period, Sinking fund deposit + Interest earned on sinking fund = principal
repaid

4) For each period, the Net amount of loan = Outstanding loan balance

Net amount of loan concept plays the same role for the sinking fund method that the
outstanding loan balance does for the amortization method.
• Consider the situation in which the interest rate on the loan and the interest
rate earned on the sinking fund differs.

• The rate on the loan is denoted by 𝑖, and

• the rate on the sinking fund is denoted by 𝑗.

• Usually, 𝑗 is less than 𝑖 because the sinking fund wouldn’t normally be riskier
than the loan.

• In this case, an amount of 𝑖 will be deducted from the sinking fund deposit and
the remaining amount will be invested in the sinking fund at a rate of 𝑗.
Example 39.3

Create a sinking fund schedule for a loan

of $1,000 repaid over four years if the
annual effective rate of interest is 10% and
the sinking fund interest of 8%.
 Example 39.2
John borrows 10,000 for 10 years at an annual effective interest rate of
10%. He can repay this loan using the amortization method with
payments of 1,627.45 at the end of each year. Instead, John repays the
10,000 using a sinking fund that pays an annual effective interest rate of
14%. The deposits to the sinking fund are equal to 1,627.45 minus the
interest on the loan and are made at the end of each year for 10 years.
Determine the balance in the sinking fund immediately after repayment
of the loan. >> Practice Problems Set 39
 Example 1
Lauren takes out a loan of $35,000. She pays this back by
establishing a sinking fund and making 16 equal payments at the
end of each year. The sinking fund earns 9% each year.
Immediately after the 9th payment the sinking fund’s yield
increases to 11%. At this time Lauren adjusts her sinking fund
payment to X so that the fund will accumulate to $35,000, 16
years after the original loan date. Find X.
 Example 2
Aiden takes out a 30 year loan for $24,000 to be repaid with
payments at the end of each year consisting of interest on the
loan and a sinking fund deposit. Interest is charged at a 16%
annual rate. The sinking fund’s annual rate is 11%. However,
beginning in the 13th year, the annual effective interest rate on
the sinking fund drops to 8%. As a result, the payments are
increased by X. Calculate X.
 Example 3
The Federal National Mortgage Association puts $30 million at
the end of each month into a sinking fund paying 4.8% interest
compounded monthly. The sinking fund is to be used to repay
bonds that mature 15 years from the creation of the fund. How
large is the amount of bonds, assuming that the sinking fund will
exactly pay it off?