5

MATHEMATICS
OF FINANCE

Copyright Cengage Learning. All rights reserved.

5.3

Amortization and
Sinking Funds

Copyright Cengage Learning. All rights reserved.

Amortization of Loans

Amortization of Loans
The annuity formulas may be used to answer questions
involving the amortization of certain types of installment
loans.
For example, in a typical housing loan, the mortgagor
makes periodic payments toward reducing his or her
indebtedness to the lender, who charges interest at a fixed
rate on the unpaid portion of the debt.
By thinking of the monthly loan repayments R as the
payments in an annuity, we see that the original amount of
the loan is given by P, the present value of the annuity.
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Amortization of Loans
From

we have
(12)

Amortization of Loans
A question a financier might ask is: How much should the
monthly installment be so that a loan will be amortized at
the end of the term of the loan? To answer this question,
we simply solve Equation (12) for R in terms of P, obtaining

Applied Example 1 Amortization Schedule

A sum of $50,000 is to be repaid over a 5-year period
through equal installments made at the end of each year.
If an interest rate of 8% per year is charged on the unpaid
balance and interest calculations are made at the end of
each year, determine the size of each installment so that
the loan (principal plus interest charges) is amortized at the
end of 5 years.
Verify the result by displaying the amortization schedule.

Applied Example 1 Solution

Substituting P = 50,000, i = r = 0.08 (here, m = 1), and
n = 5 into

we obtain

giving the required yearly installment as $12,522.82.

8

Applied Example 1 Solution

contd

The amortization schedule is presented in Table 4.

Table 4

Applied Example 1 Solution

contd

The outstanding principal at the end of 5 years is, of

course, zero.(The figure of $0.01 in Table 4 is the result of
round-off errors.)
Observe that initially the larger portion of the repayment
goes toward payment of interest charges, but as time goes
by, more and more of the payment goes toward repayment
of the principal.

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Financing a Home

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Applied Example 2 Home Mortgage Payments

The Blakelys borrowed $120,000 from a bank to help
finance the purchase of a house.
The bank charges interest at a rate of 5.4% per year on the
unpaid balance, with interest computations made at the
end of each month.
The Blakelys have agreed to repay the loan in equal
monthly installments over 30 years. How much should each
payment be if the loan is to be amortized at the end of the
term?
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Applied Example 2 Solution

Here, P = 120,000,
n = (30)(12) = 360.

and

Using

we find that the size of each monthly installment required is

given by

or $673.84.
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Applied Example 4 Home Affordability

The Jacksons have determined that, after making a down
payment, they could afford at most $2000 for a monthly
house payment.
The bank charges interest at the rate of 6% per year on the
unpaid balance, with interest computations made at the
end of each month.
If the loan is to be amortized in equal monthly installments
over 30 years, what is the maximum amount that the
Jacksons can borrow from the bank?
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Applied Example 4 Solution

Here,

n = (30)(12) = 360, and

R = 2000; we are required to find P.

From

We have

15

Applied Example 4 Solution

contd

Substituting the numerical values for R, n, and i into this

expression for P, we obtain

Therefore, the Jacksons can borrow at most $333,583.

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Financing a Home
An adjustable-rate mortgage (ARM) is a home loan in
which the interest rate is changed periodically based on a
financial index.
For example, a 5/1 ARM is one that has an initial rate for
the first 5 years and thereafter is adjusted every year for
the remaining term of the loan.
Similarly, a 7/1 ARM is one that has an initial rate for the
first 7 years and thereafter is adjusted every year for the
remaining term of the loan.
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Sinking Funds

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Sinking Funds
Sinking funds are another important application of the
annuity formulas. Simply stated, a sinking fund is an
account that is set up for a specific purpose at some future
date.
For example, an individual might establish a sinking fund
for the purpose of discharging a debt at a future date.
A corporation might establish a sinking fund in order to
accumulate sufficient capital to replace equipment that is
expected to be obsolete at some future date.
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Applied Example 7 Sinking Fund

The proprietor of Carson Hardware has decided to set up a
sinking fund for the purpose of purchasing a truck in
2 years time.
It is expected that the truck will cost $30,000. If the fund
earns 10% interest per year compounded quarterly,
determine the size of each (equal) quarterly installment the
proprietor should pay into the fund.
Verify the result by displaying the schedule.

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Applied Example 7 Solution

The problem at hand is to find the size of each quarterly
payment R of an annuity, given that its future value is
S = 30,000, the interest earned per conversion period is
, and the number of payments is
n = (2)(4) = 8.
The formula for an annuity,

21

Applied Example 7 Solution

contd

When solved for R yields

(14)

or, equivalently,

22

Applied Example 7 Solution

contd

Substituting the appropriate numerical values for i, S, and n

into Equation (14), we obtain the desired quarterly payment

or $3434.02.

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Applied Example 7 Solution

contd

Table 5 shows the required schedule.

Table 5

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Sinking Funds
The formula derived in this last example is restated as
follows.

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Sinking Funds
Here is a summary of the formulas developed are as
follows
1. Simple and compound interest; annuities

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Sinking Funds
2. Effective rate of interest

3. Amortization
Periodic payment

Amount amortized

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Sinking Funds
4. Sinking fund
Periodic payment taken out

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