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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 • 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
 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 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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