MATHEMATICS OF FINANCE

6- Amortisations
A loan is said to be amortised when all liabilities are paid by a sequence of equal
payments made at equal intervals of time, where the liabilities consist of both
principal and interest.
100 000
1 2 3 4 5 6 7
               
               
0 ↓ ↓ ↓ ↓ ↓ ↓ ↓

PMT PMT PMT PMT PMT PMT PMT

The philosophy behind amortisations is quite the same as that behind annuities.
From the figure above we can see that we have seven payments of an ordinary
annuity with a present value of $ 100 [Link] illustrates an amortization problem .
A loan of a present value of $100 000 must be amortised over seven payments at a
certain interest rate (i) per payment interval. What is the amount of each payment
(PMT)? As pointed out in the in the example, the seven payments form an
ordinary annuity ; hence we can use the formula of the present value of such an
annuity to calculate the payment(PMT), namely;

1
1−
( 1+i )n
Pa=Pmt ⌊ ⌋
i

Rearranging the formula the get the value of PMT we have

i
Pmt=Pa ⌊ ⌋
1
1−
( 1+i )n

1
While in ordinary annuities the payments are given and we need to determine the
sum or the principal, in amortisations we know the principal all we need is to
determine the payments.

To best understand the mechanics of amortisations we will take one example:

Example 1
You purchase a house for $100 000 for which you secure a mortgage bond with a
bank at 12% per annum compounded monthly, with a term of 20 years. What are
the monthly payments?
Solution:
Data
P= $100 000
r=12%
t=20
m=12
i=0.01
n=240
Pmt=?
i
Pmt=P ⌊ ⌋
1
1−
( 1+i )n
0.01
Pmt=100 000∗⌊ ⌋
1
1−
( 1+0.01 )240
Pmt=1 101.09

2
Here, initially the total amount loaned $ 100 000 ( the present value at instant 0) is
owed. However, as payments are made, the outstanding principal, or liability
decreases until it is eventually zero at the end of the term. At the end each payment
interval, the interest on the outstanding principal is first calculated. The payment
PMT is then first used to pay the interest due. The balance of the payment is
thereafter used to reduce the outstanding principal. ( if, for some reason of another,
e.g. by default, no payment is made, the interest owed is added to the outstanding
principal and the outstanding debt then increases. usually, this will be accompanied
by a rather strongly worded letter of warning to the debtor) Since the outstanding
principal decreases with time, the interest owed at the end of each period also
decreases with time. This means that the fraction of the payment which is available
for reducing the principal increases with time.
Note that, at any stage of the term, the amount outstanding just after payment has
been made is the present value of the payments which still have to be made.
The above concepts are all embodied and illustrated in the amortization schedule,
which is a table indicating the distribution of each payment with regards to interest
and principal reduction. This is illustrated in the following example.
Example 2
Draw up an amortization schedule for a loan of 50 000, 00 MZM which is repaid
in annual payments over five years at an interest rate of 28% per annum.
Solution:
P= 50 000,00MZM
i=28%
n=5
Pmt=?
i
Pmt=Pa ⌊ ⌋
1
1−
( 1+i )n
0.05
Pmt=100 000❑ ⌊ ⌋
1
1−
( 1+ 0.05 )5

3
Pmt=1 491.58 MZM ❑

Year Outstanding principal Interest due at Payments Principal

  at year beginning year end   repaid

1 50,000.00 14,000.00 19,747.19 5,747.18

2 44,252.81 12,390.81 19,747.19 7,356.40

3 36,896.41 10,331.00 19,747.19 9,416.19

4 27,480.22 7,694.46 19,747.19 12,052.74

5 15,427.49 4,319.70 19,747.19 15,427.49

Total   48,735.97 98,735.95 50,000.00

Note:
a) The interest due at the end of each year is simply 28% of the outstanding
principal.
b) The principal repaid is the diference between the payment and the interest
due
c) Outstanding princila at year beginning is equal to the previous principal at
year beging minus principal repaid.

As stated above, and as well illustrated in the above amortization schedule, the
outstanding principal decreases over the term from the amount initially borrowed
to zero at the end. In the case where loan is used to by property, thi means that, as
the amount owed to the lender decreases, the fraction of the property that the buyer
has “paid off” increases until, at the end of the term the owes nothing on his
property, which is then paid off in full. At any stage during the term, the part of
the price of the property which the buyer has paid off is called buyers equity and
the part of the price of the property which remais to be paid is called the sellers
equity. Obviously by definition, we have the following relationship between the
two:

4
Sellig price=buyers equity +Sellers equity.
The consolidade your knowledge of annuities do the following exercises and I will
provide you with solutions tomorrow.
Exercise 1
Your great aunt Tina dies and leaves you an inheritance of $30 000 which is to be
paid to you in 10 equal payments, at the end of each year for the next 10 years. If
money is invested at 12% per annum, how much do you receive each year?
Exercice 2
Draw up an amortization schedule for 40 000,00MZM for three years at 12% per
annum compounded half-yearly and repayable in six half-yearly payments?
Exercise 3
Edgar purchases an apartment by making a down payment of $ 10 000, and obtains
a 10 years loan for the balance of $40 000 at 14% per annum, compounded montly.
After four and half years, the bank adjusts the interest rate to 16%. What is the new
amount which he must pay if the term of the loan remains the same?
Exercise 4
Suppose the interest rate on Edgars loan of $40 000 remain fixed at 14% for the
full term of the loan. What is the total real cost of the loan if the expected average
rate of inflation over the term of the loan is 8% per year.
Exercise 5

1- A new vehicle with a price of R 2000 000 is sold by means of leasing

arrangement, to be repaid monthly for 3 years at 18% per annum
compounded monthly. What will be the amount of payments if the first
payment is made at the end of the second month ?

Exercise 6

2- A new BMW is released and ACB bank offers to finance the vehicle to be
repaid in 60 monthly instalments of R38 967. What is the price of the
vehicle if the first payment is made at the end of the 4 th month and the bank
charges 24% per annum compounded monthly?

5
6
7