SIQ2003

Financial Mathematics and Derivatives

Chapter 6: Loans

Lecturer: Nadiah Zabri

Institute of Mathematical Sciences

Faculty of Science
University Malaya
 Outline

Amortizing a loan
1 Loan
Varying series of payments
Equal Principle repayments
Final Payments (Baloon and drop payments)
Sinking fund Method of loan repayment
Loan refinancing

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 Loan Amortizing a Loan

Amortizing a loan
§ Amortize means: Gradually write off the initial cost of an asset or
gradually pay-off a debt

§ After loan is given, its usually paid by a series of payments

(commonly level payment) to pay off the original loan amount,
principal.
§ Each loan payment will contribute to:

Interest Reduce
due principle
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 Loan Amortizing a Loan

Illustration for a level payment loan

Below is a loan at 5% annual effective interest rate
Loan=709.19

t=0 t=1 t=2 t=3 t=4

200 200 200 200

709.19 = 200𝑎! ⃧
The loan payment is level, so the payments is a level annuity
Reduce as OS balance ( remaining principal) reduces

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 At each time payment is due,t, there will be these following values:

𝐼! = interest paid at time t

𝑃! = Principal repaid at time t
𝐵! = Outstanding loan balance at time t (after loan payment is made)
𝑅! = Loan repayment amount (200 in our example)

The process of writing-off the principal with payments that pay part
interest part principle is called loan amortization

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 • Loans can be paid by any payment schedule. It will still follow the
basic relationships for loan amortization

𝐼! = 𝑖𝐵!"# 𝑃! = 𝑅! − 𝐼! 𝐵4 = 𝐵456 − 𝑃4

𝐵"
𝐼! = 5%709.19 𝑃! = 200 − 35.46 = 709.19 − 164.54
= 35.46 = 164.54
=544.65

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Another useful relationship:
Especially useful when 𝐵! is harder to compute and when you are given
the 𝑃! 𝑎𝑛𝑑 𝑅! info directly

• You can derive this by doing 𝑃! − 𝑃!"# :

𝑃! − 𝑃!"# = (𝑅! − 𝐵!"# 𝑖) − (𝑅!"# − 𝐵!"$ 𝑖)
= 𝑅! − 𝑅!"# + (𝐵!"$ − 𝐵!"# )i
= 𝑅! − 𝑅!"# + (𝑃!"# )i
𝑃! = (𝑅! − 𝑅!"# ) + 𝑃!"# (1 + 𝑖)
• So for the first repayment of RM200, the following is the
breakdown:
35.46 200
164.54
interest
principal Payment
payment,
repaid, 𝑃! in t=1, 𝑅!
𝐼!

• Over time, the proportion of interest and principle within the

RM200 level payment changes:
-Interest due, 𝐼! reduces
-Principle paid off, 𝑃! increases
• For a level payment loan paid in arrears with n repayments, the
PROPORTION of loan payment going to interest vs principal,
follows a convenient formula:
𝐼" = 𝑅" 1 − 𝑣 #$ "$!
𝑃# = 𝑅# 𝑣 $%(#%")
Later payments will have LESS 𝐼! Later payments will have MORE 𝑃!

𝐼" = 200 1 − 𝑣 ! =200*0.177=35.46 𝑃" = 200 𝑣 ! = 200 ∗ 0.823=164.54

-The one in yellow font represent PROPORTION

-You will understand this derivation of formula more later
 Loan Amortizing a Loan

Outstanding balance
§ After some payment(s), there is 2 ways to compute outstanding
balance (OS) or principal at time t, 𝐵# , (after payment at time t is
made)

Ways of evaluating
Outstanding
balance

Retrospective Prospective
method method

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 1. Retrospective method. Looking backward considering all payments made
Loan=709.19

t=0 t=1 t=2 t=3 t=4

200 200 200 200

OS balance(t)

=Original principle− 𝐴𝑙𝑙 𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑙𝑒 𝑝𝑎𝑖𝑑 𝑢𝑝 𝑡𝑜 𝑡𝑖𝑚𝑒 𝑡

= 𝐴𝑉 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑡 𝑜𝑓 𝑙𝑜𝑎𝑛 − 𝐴𝑉 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑡 𝑜𝑓 𝑎𝑙𝑙 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑 𝑏𝑒𝑓𝑜𝑟𝑒 𝑎𝑛𝑑 𝑎𝑡 𝑡.

OS balance(t=1)=709.19 − (200 − 709.19 ∗ 0.05) = 709.19 1.05 − 200 = 544.65,

If the periods involve varying interest rate, need to allow for the varying interest.

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 Loan Amortizing a Loan

2. Prospective method. Looking forward considering PV at time t of all

remaining payments
Loan=709.19

t=0 t=1 t=2 t=3 t=4

200 200 200 200

OS balance(t=1) = 200𝑎# ⃧ =544.65

If the period involve varying interest rate, need to allow as such

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 • Lets make sense of the convenient formula used for 𝐼# and 𝑃# when
loan payments are level:

• 𝐼# = 𝑖𝐵#%"

• If the retrospective method is used to compute 𝐵"$! :

!$' () *)+
𝐵"$! = 200𝑎#$("$!) ⃧ = 𝑅"
(
*n-(t-1) is the number of payments remaining at the beginning of the payment
period
!$' () *)+
So 𝐼" = 𝑖𝐵"$! = 𝑖 ∗ 𝑅" = 𝑅" 1 − 𝑣 #$ "$! .
(

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• So here is an example. A loan is paid with 5 level payment of 1000,
interest rate is 5%.

t 𝐼! 𝑷!

1 1000 1 − 𝑣 " . 1000 𝑣 !

2 1000 1 − 𝑣 # . 1000 𝑣 "

3 1000 1 − 𝑣 $ . 1000 𝑣 #

4 1000 1 − 𝑣 % . 1000 𝑣 $

5 1000 1 − 𝑣 & . 1000 𝑣 %

 Loan Amortization schedule

1) Interest Content of
Payment at time t = OS
balance at time t-1*i

2) Capital repaid= payment

(1)- interest content of
payment

3) OS balance at time t

Garrett, S. J. (2013)

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 Loan for a mthly annuity
§ Loans can also be paid in mthly installments. It is very common
that loans is paid monthly like home /car loan etc.
§ The loan schedule is best derived using mthly effective interest
) (")
rate, j = * .
§ The schedule wont differ from annual schedule but now the time
unit is a portion of the year.

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 Varying loan payments
§ Loans can be paid by any payment schedule. It will still follow the
basic relationships for loan amortization.
§ However, we might not have convenient formulas to derive each
component of the loan at each time, t. It must solely be dependant
on values from adjacent payment period.

𝐼! = 𝑖𝐵!"# 𝑃! = 𝑅! − 𝐼! 𝐵4 = 𝐵456 − 𝑃4

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 Varying series of Payments
§ Sometimes payment is less than interest due resulting in negative
amortization which will “capitalizes the interest shortfall”
§ A 3-year loan for $10,000 at 10% annual interest but the payments
are 600, 5000 and 7084. Build the amortization schedule:
Time, t Payment, 𝑹𝒕 Interest Paid, 𝑰𝒕 Principal repaid, 𝑷𝒕 Outstanding
Balance, 𝑩𝒕

0 10,000
1 600 1000 -400 10400
2 5,000 1040 3960 6440
3 7,084 644 6440 0
Total 12,684 2,684 10,000

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 Exercise
§ A loan is being repaid by a series of annual non-level payments at
10% effective. The t-th payment is $2,000 and the principal paid
from this payment is $1,000. The next payment is $3,000. How
much principal is contained in this payment?
𝐼# = 𝑅# − 𝑃# =2000-1000=1000
𝐵#%" 10% = 1000
𝐵#%" = 10,000
𝐵# = 𝐵#%" − 𝑃# = 10,000 − 1000 = 9000

Next Payment is
𝑅#+" = 𝐼#+" + 𝑃#+" =3000= 𝐵# ×10%+ 𝑃#+" =900+ 𝑃#+"
𝑃#+" = 3000 − 900 = 2100

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 Equal principal repayments (special case of
Varying payments)
When principle payments is level, how will the monthly payments
be?

Increasing Or Decreasing

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 Exercise
A loan of $10,000 is being repaid over 10 years by equal principal
payments plus interest on unpaid balance at an effective rate of i. If
the total interest paid in the 3rd to 8th years, inclusive is 2541,
determine i.
8000i+7000i+….3000i=2541

Arithmetic progression formula:

n(,$+ ,%) 6(.///)+ 0///))
= =33,000i=2541
- -
i=7.7%

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 Final Payment ( Baloon or drop payments)
§ For a level payment, usually the Payment is not a nice round number.
§ Common way is to choose a good round number as payment and then
adjust the final payment accordingly to settle the last OS balance.
1. A final payment larger than the
regular amount. This is called a balloon
payment.

2. A final payment smaller than the

regular amount. This is called a drop
payment.

§ To calculate the last payment, first need to: determine OS balance after
the last regular payment, then allow of interest earned between 2nd last
and last payment

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 Example
§ A loan of $10,000 is to be repaid at 5% effective by payments of
$1,000 at the end of each year until the loan is repaid.
n is supposed to be 14.2
Option 1: A final payment with larger than regular, at time 14
(balloon payment)

𝐵"! = 𝐴𝑉 𝑙𝑜𝑎𝑛 𝑎𝑡 𝑡𝑖𝑚𝑒 14 − 𝐴𝑉 𝑎𝑙𝑙 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑚𝑎𝑑𝑒 𝑎𝑡 𝑡𝑖𝑚𝑒 14

= 10,000*(1.05)"! − 1000 𝑠"! ⃧ =200.68

So payment at time 14 is 1000+200.68=1200.68

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 § Option 2, A final payment smaller than regular at time 15.(drop
payment)

If the drop payment is paid following normal payment interval, then the
last payment will be:

AV of loan balance after last regular payment, to last payment time=

𝐵#, a(14,15)=200.68*(1.05)

As usual, last payment will include=

1) Interest= 𝐵!"# *i=200.68*0.05
2) Principle=200.68

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 Sinking fund method of loan repayment
§ For a initial loan of L, payment schedule for sinking fund method is
as follows:

Within loan period n:

-pay interest only at rate of i At time n:
-accumulate fund in sinking fund, Payment of whole
at rate j, for principle payoff at principle
time n

§ Interest for loan and return in sinking fund can differ.

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 • One example of a loan amortized via a sinking fund method is
where a company issue bonds as source of capital for a project.
• The bond is expected to be pay “ interest only” and full principle
amount to be paid at the end.

• For company that get financing by bond issuance, they sometime

hold a bond sinking fund as an escrow account, into which a
company places cash that it will eventually use to retire their bond
liability, when due.

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 Outstanding Loan (minus) 𝑃
Accumulated
balance at amount in sinking
P−
𝑠$ ⃧ j
×𝑠% ⃧ j

time t, 𝐵G fund up to time t

Formula above is if the deposit to the sinking fund is constant throughout. If not
level, there is no convenient formula but concept still the same
 Principle Interest
Regular
repaid at earned from
deposit to
time t, Pt Sinking
sinking
fund from
= 𝐵!(& −𝐵! fund
𝐿 − 𝐵!(&

Interest
Interest
earned from
paid from Interest
Sinking
regular Due, Li
fund from
payment, 𝐼!
𝐿 − 𝐵!(&

Loan payment, 𝑅!
Loan payment, 𝑅!
 • Sinking fund loan repayment schedule
loan amount 5000
level deposit for sinking fund Level interest due, Li Total level payment due
tenure 10
j 5% 398 350 748
i 7%

time Loan- accumulation Amount in the sinking fund Level deposit to sinking fund Level interest due- int
in SF + int earned from sinking earned in sinking
fund fund
Reduction in OS balance, Remainder of
B(t-1)-B(t) regular payments
B(t) P (t) I(t)
0 5000 0
1 4602 398 398 350
2 4185 815 417 330
3 3747 1253 438 309
4 3287 1713 460 287
5 2803 2197 483 264
6 2296 2704 507 240
7 1763 3237 533 215
8 1204 3796 559 188
9 617 4383 587 160
10 0 5000 617 131
 example
§ A loan of 100,000 is to be repaid by ten annual payments
beginning one year after the loan is made. The lender wants
annual payments of interest at a rate of 10% and repayment of the
principal in a single lump sum at the end of 10 years. The
borrower can accumulate the principal in a sinking fund earning
an annual interest rate of 8%, and decides to do this by means of
10 level deposits starting one year after the loan is made.

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• (a) Find the borrowers’ total annual payment and compare this to
the level annual payment required by the regular amortization
method at 10%.

• Normal loan.
100,000=PMT 𝑎"/ ⃧ 10%
PMT=100,000/6.145=16,273

Sinking fund loan

PMT=regular deposit to sinking fund+ return for investment due=
"//,///
+ 100,000 ∗ 10%=6902+10,000=16,902
2$& ⃧ "%
 § What is OB at time 5?
§ 𝑂𝐵3 =loan –accumulated SF= 100,000-6,902 𝑠3 ⃧ 8%=100,000-
40491=59,508
§ What is the principle paid at time 6?
§ 𝑃# =𝑂𝐵#%" − 𝑂𝐵#
§ 59,508-49367=10,141.3 or
§ Interest from Whats left is sinking fund at 5+level deposit to
sinking fund at time 6
§ =(100,000-59508)*8%+6902=10,141.3

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 Loan refinancing
§ Loan refinancing is basically changing the original terms of your
loan. The changes can be on:
• Interest rate
• Period of repayment
• Repayment schedule ( from level to varying etc, but level is the most
common)
• Outstanding balance (maybe borrower pays partial early settlement to
expedite the repayment).

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 Loan refinancing
§ Why would one need to refinance loan:

Take advantage of • Reduce cost of loan.

lower interest • In reality, loan refinancing have extra cost like lawyer’s fee etc, so
only when the interest drop sufficient will this be worth it.
environment
Change monthly
• Increase regular payment and hasten repayment
payment to suit • Drop regular payment and slow repayment
affordability

Consolidate multiple • Easier to manage and keep track

loans to one

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 • General step to solve loan refinancing problem

Equate that to the

Find OS balance
PV of the future
at point of
payments under
refinancing
the revised term

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 Summary:
§ Loan amortization

Loan
Principle Interest
Repayment,
repaid, P! Paid, P!
𝑅!

𝐼! = 𝑖𝐵!"# 𝑃! = 𝑅! − 𝐼! 𝐵4 = 𝐵456 − 𝑃4

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• Another useful relationship for amortization:

• For a level payment loan, paid in arrears with n repayments, the

PROPORTION of loan payment going to interest vs principal, follows a
convenient formula:

𝐼" = 𝑅" 1 − 𝑣 #$ "$!

𝑃! = 𝑅! 𝑣 "#(!#%)
• *n-(t-1) is the number of payments remaining at the beginning of the
payment period
 Ways of evaluating
Outstanding
balance at t

Retrospective Prospective
method method
𝐴𝑉% of loan- AV of all payments up to t PV of remaining payments
 Principle Interest
Sinking fund loan payment Regular
repaid at earned from
deposit to
time t, Pt Sinking
sinking
fund from
𝐵!(& − 𝐵! fund
𝐿 − 𝐵!(&

Interest
Interest
earned from
paid from Interest
Sinking
regular Due, Li
fund from
payment, 𝐼!
𝐿 − 𝐵!(&

Loan payment, 𝑅!
Loan payment, 𝑅!
Outstanding Loan-
Accumulated
balance at amount in sinking
time t, 𝐵G fund up to time t