Financial Mathematics

Lesson 9

Prof. María Jesús Segovia Vargas

1. Amortization of a debt:
repayments
2. Static and dynamic study
3. Amortization Schedules
4. Financial Value of a loan

2
1.- Amortization of a debt: Repayments

It is a gradual repayment of interest-bearing debt (credit, loan) by its debtor

(borrower) to its creditor (lender) according to an amortization schedule (repayment
plan).

Features: It is a compound financial transaction.

The transaction schedule is the following. Note that the first payment is normally made
immediately (at point 0), but the repayments are made at the end of the time interval.
Therefore, it is an ordinary annuity.

 Payment, {(C0, t0}

 Repayments: {(a1, t1), (a2, t2), (a3, t3),…, (an, tn)}

 The transaction schedule is the following.

C0 a1 a2 a3 as an-1 an
|--------|--------|--------|----------------|--------|--------|
t0 t1 t2 .... t3 .... ts .... tn-1 tn

As we can see this is the most general case, that is, the payments are different.

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2.1. Static study

(C0, t0 ) is the financial capital at t0 which verifies the equation of equivalence between
the payment and the repayments of the transaction.

This equivalence is normally calculated at the beginning of the transaction (t0) because
it is easier but it is possible to calculate it at the end of the transaction.

If the interest rates are variable (general case), the equation of equivalence is:

• At t0 n r

 ar  1  ih 
1
Co 
• At tn r 1 h 1

n n 1 n
C0  (1  ih )   ar  (1  i )  a
h n
h 1 r 1 h  r 1

where:

ih : interest rates for each period (compound interest)

4
2.2. Dynamic study

Cs, is the mathematical reserve of the loan at ts. It shows the amount of principal
remaining to be paid at a certain time. Therefore it is the outstanding balance. Unlike
the sinking fund transaction, the mathematical reserve is calculated via the right hand
side.

The easiest way of calculating the reserve is using the prospective method (but it is
possible to use the retrospective method too). Therefore:

n r

  1  ih 
1
Cs  ar
r  s 1 h  s 1

where:

ih : interest rates for each period (compound interest)

We can use the retrospective method too:

r s 1 r
Cr  C0  (1  ih )  [  ar  (1  i
h )  ar ]
h 1 r 1 h  r 1

5
If we calculate, the mathematical reserve using the iterative method, in the time
interval (ts, ts+1), the following relationships between the variables are satisfied:

Cs  C s 1 (1  is )  as
finding a s
as  C s 1  C s  C s 1  is

Therefore,
as  C s 1  C s  C s 1is
As Is
Where:

Cs: Mathematical Reserve or outstanding balance at ts

Cs-1: Mathematical Reserve or outstanding balance at ts-1

as: instalment or repayment at ts.

As: Payment on principal at ts

Is: Payment on interest at ts. Be careful!!! Unlike the sinking fund, we multiply the
outstanding balance in the previous period by the interest rate of the period.

6
As we can see, each repayment (instalment) in this schedule is comprised of two
components:

- Payment on principal: it reduces the principal of the debt (unpaid balance)

gradually.
- Payment on interest: it settles interest from the unpaid balance of the debt
according to the given credit interest rate.

Consequently:

as  A s  I s
It is important to know how much of each loan payment goes toward interest and how
much goes to reducing the principal for several reasons, one of them is for tax
reduction.

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Also, these three variables verify the following relations:

◦ The arithmetical sum of all the payments on principal (“principal

payment”) is equal to the original amount of the loan (C0) at t0.
n
C0  
h 1
h

◦ The arithmetical sum of the payments on principal (“principal

payment”) up to ts, is equal to outstanding balance at this moment, that
is, the mathematical reserve at ts:
n
Cs  
h  s 1
h

◦ The amortized financial capital is calculated as the difference between

the original amount of the loan and the outstanding balance: Principal
repaid
Cn  C s  M s
s
Ms  
h 1
h

8
Graph of an amortization schedule

In the evolution of the mathematical reserve we can see:

• at the beginning of the loan (t0)→C0

• at the end of the loan (tn)→Cn=0

9
For example, in the schedule we can see the following relationships:

C0  C1  A 1
C1  C2  A2
C2  C3  A 3
C2  A 3  A 4
M 2  A1  A 2

Tip: In some periods, it is possible that the instalments equal zero (no payment). In
this situation the debt increases unless we pay the interests. In this last case the debt
remains equal.

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The repayments can be:

- Unequal
- Equal (the so-called annuity amortization of a debt).
- They only pay interests and the principal is paid at the end.
- Repayments always amortize the same part of the principal.

Focusing on the last three cases, we can consider the following typology:

◦ Annuity amortization. (French Loan)

◦ Interest amortization (American Loan)

◦ Uniform amortization (Italian Loan)

The amortization schedule can be represented in a table, which details the periodic
payments on an amortizing loan.

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3.1.- Annuity amortization (FRENCH LOAN): as=a and is=i

This method is used to liquidate an interest-bearing debt by means of a series of

periodic payments, a, usually equal and the interest rate of debt, i, is also constant
throughout the lifespan of the loan.

Financial Equivalence (equation of value at t0) using compound interest:

 Initial principal (payment): {(C0, t0)}

 Repayments: {(a, t1), (a, t2), (a, t3),…, (a, tn)}

 1  1  i   n 
C0  a a n i  a 
 i 
 

Outstanding balance or mathematical reserve (right hand side): Equation of value at

(ts-1, ts).

•prospective method: C s  a an  s i
•retrospective method:
C s  C0 (1  i ) s  a as i

•iterative method:
Cs  Cs 1 (1  i )  a (1)
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The mathematical reserve for the previous period calculated using the iterative
method is:

Cs 1  Cs  2 (1  i )  a (2)

Calculating the difference between (1) and (2), we can obtain the following
relationship:
t s  As  As 1 1  i 
 Cs: Outstanding balance at ts

 Cs-1Outstanding balance at ts-1

 As: Principal Payment at ts repayment

 As-1: Principal Payment at ts-1 repayment

 a : Constant repayment throughout the lifespan of the loan.

Therefore the relationship between two consecutive principal payments is (1+i).

Consequently, the principal payments vary in terms of a common ratio (1+i) and

A1  a  I1  a  C0i

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 Amortization schedule: Annuity Amortization method
Payments
(years) 10

Annual
Effective
Rate 3,00%

Payment Outstanding Principal Interest Annual Principal

Number Rate Balance Payment Payment Payment Repaid
0 6.000.000,00 €
1 3,00% 5.476.616,96 € 523.383,04 € 180.000,00 € 703.383,04 € 523.383,04 €
2 3,00% 4.937.532,43 € 539.084,53 € 164.298,51 € 703.383,04 € 1.062.467,57 €
3 3,00% 4.382.275,36 € 555.257,07 € 148.125,97 € 703.383,04 € 1.617.724,64 €
4 3,00% 3.810.360,58 € 571.914,78 € 131.468,26 € 703.383,04 € 2.189.639,42 €
5 3,00% 3.221.288,36 € 589.072,22 € 114.310,82 € 703.383,04 € 2.778.711,64 €
6 3,00% 2.614.543,97 € 606.744,39 € 96.638,65 € 703.383,04 € 3.385.456,03 €
7 3,00% 1.989.597,25 € 624.946,72 € 78.436,32 € 703.383,04 € 4.010.402,75 €
8 3,00% 1.345.902,13 € 643.695,12 € 59.687,92 € 703.383,04 € 4.654.097,87 €
9 3,00% 682.896,15 € 663.005,98 € 40.377,06 € 703.383,04 € 5.317.103,85 €
10 3,00% 0,00 € 682.896,15 € 20.486,88 € 703.383,04 € 6.000.000,00 €

6.000.000,00 €

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3.2. Interest amortization (AMERICAN LOAN)

One repays only interests and the principal is amortized at the end. An=C0

•When the interest rates vary:

Initial principal, {(C0, t0)}

The payments will be: {(C0 i1, t1), (C0 i2, t2), (C0 i3, t3),…, (An+C0 in, tn),}

The financial equivalence (equation of value) at t0 if the effective rates vary (ih):

n r n

 C i  1  i   An  1  ih 
1 1
C0  0. r h
r 1 h 1 h 1

• When the interest rates are constant

 Initial principal, {(C0, t0)}

 Repayments: a1=I; a2=I; an-1=I and

an=I+An=I+C0= C0 i+ C0=. C0 (1+i).

Knowing that “i” is constant, the interests will be constant too, that is, I=C0 i.
Therefore the repayments will be:

{( C0 i, t1), (C0 i, t2), (C0 i, t3),,…, (An+ C0 i, tn),}

 Financial Equivalence (equation of value):

C0  C0 i an i  C0 (1  i )  n

 Mathematical reserve or outstanding balance:

Cs  C0  s  1, 2, 3,...., n  1
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Sinking Fund Loan

This amortization schedule has a problem: at the end of the loan a great amount of
money is needed because there were no payments on principal.

Therefore, this amortization schedule is combined with a sinking fund. The sinking
fund is used to pay off the debt. Consequently we have a sinking fund schedule and an
amortization schedule.

The method consists of paying the interest on the loan at the end of each interest
period and paying the principal in one lump sum at the end of the term of the loan. To
repay the principal amount, the borrower pays a periodic deposit during the
transaction. In this way, the borrower is making two series of payments: First, it is the
interest payments to "American loan“, second it is the deposits into of sinking fund.

Example

One bank grants a loan €10,000,000 to be amortized over 5 years. The method applied
is the Sinking Fund Loan. Taking into account that the amounts deposited into the fund
are invested at a 10% annual interest rate and the annual interest rate of loan is 12%,
determine the schedule of financial transaction:

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Solution

The calculations are the following:

Interest on the loan:

I = 10.000.000 * 0,12 = 1.200.000

Deposits:

10.000.000=a S5|10 a = 1,637,975

The joint transaction is showed in the next table:

Loan Sinking Fund Joint Transaction

year: n Interest Paym. Deposit Accumul.amount Total Payment Net balance
0 10000000
1 1200000 1637975 1637975 2837975 8362025
2 1200000 1637975 3439748 2837975 6560252
3 1200000 1637975 5421697 2837975 4578303
4 1200000 1637975 7601441 2837975 2398559
5 1200000 1637975 10000000 2837975 0

A1=1637975→ M1=1637975

A2=1637975(1+0.1)= 1801772,5 M2= A1+ A2=3439748

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3.3. Uniform Amortization (ITALIAN LOAN)

Repayments always amortize the same part of the principal: A=C/n.

Therefore, if as we have seen As=A ɏ s, the following relationships are satisfied:

n
C0
C0  A
h 1
h  nA  A 
n

The outstanding balance or mathematical reserve at t s equals the arithmetic sum of

the outstanding principal payments, that is:
n
Cs  
h  s 1
A h  (n  s ) A

If the interest rates are constant, the mathematical reserves via the iterative method
in two consecutive periods are:

C s  C s 1 (1  i )  a s (1)
C s 1  C s  2 (1  i )  a s 1 (2)
Calculating the difference between the two previous expressions, we can see that
when the interest rates are constant, the repayments vary in arithmetical progression
of difference (ratio) –Ai:

A  A(1  i )  [ as 1  as ]

as 1  as  Ai
The first term of this progression is:

a1  I1  A1  C0i  A

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Amortization schedule: uniform amortization

Principal
of loan
6.000.000,00 €
Payments
(years) 10
Annual
Effective
Rate 3,00%

Annual
Payment Effective Outstanding Principal Interest Annual Principal
Number Rate Balance Payment Payment Payment Repaid
0 6.000.000,00 €
1 3,00% 5.400.000,00 € 600.000,00 € 180.000,00 € 780.000,00 € 600.000,00 €
2 3,00% 4.800.000,00 € 600.000,00 € 162.000,00 € 762.000,00 € 1.200.000,00 €
3 3,00% 4.200.000,00 € 600.000,00 € 144.000,00 € 744.000,00 € 1.800.000,00 €
4 3,00% 3.600.000,00 € 600.000,00 € 126.000,00 € 726.000,00 € 2.400.000,00 €
5 3,00% 3.000.000,00 € 600.000,00 € 108.000,00 € 708.000,00 € 3.000.000,00 €
6 3,00% 2.400.000,00 € 600.000,00 € 90.000,00 € 690.000,00 € 3.600.000,00 €
7 3,00% 1.800.000,00 € 600.000,00 € 72.000,00 € 672.000,00 € 4.200.000,00 €
8 3,00% 1.200.000,00 € 600.000,00 € 54.000,00 € 654.000,00 € 4.800.000,00 €
9 3,00% 600.000,00 € 600.000,00 € 36.000,00 € 636.000,00 € 5.400.000,00 €
10 3,00% 0,00 € 600.000,00 € 18.000,00 € 618.000,00 € 6.000.000,00 €

6.000.000,00 €

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 Amortization Schedule: Loan with variable rates
Payments
(years) 10
Rate VARIABLE

Payment Principal Interest Yearly Principal

Numbers Rate Outstanding balance Payment Payment Payment Repaid
0 6.000.000,00 € -6.000.000,00 €
1 3,00% 5.476.616,96 € 523.383,04 € 180.000,00 € 703.383,04 € 523.383,04 €
2 3,25% 4.942.999,75 € 533.617,21 € 177.990,05 € 711.607,26 € 1.057.000,25 €
3 3,50% 4.396.913,71 € 546.086,04 € 173.004,99 € 719.091,03 € 1.603.086,29 €
4 3,75% 3.835.983,18 € 560.930,53 € 164.884,26 € 725.814,80 € 2.164.016,82 €
5 4,00% 3.257.663,06 € 578.320,12 € 153.439,33 € 731.759,45 € 2.742.336,94 €
6 4,25% 2.659.207,43 € 598.455,63 € 138.450,68 € 736.906,31 € 3.340.792,57 €
7 4,50% 2.037.634,58 € 621.572,84 € 119.664,33 € 741.237,18 € 3.962.365,42 €
8 4,75% 1.389.687,84 € 647.946,75 € 96.787,64 € 744.734,39 € 4.610.312,16 €
9 5,00% 711.791,33 € 677.896,51 € 69.484,39 € 747.380,90 € 5.288.208,67 €
10 5,25% 0,00 € 711.791,33 € 37.369,04 € 749.160,38 € 6.000.000,00 €

6.000.000,00 €

Annual Effective
Average
Rate IRR 3,7224%

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There are other types of loans: the annuity that amortizes the loan can vary forming an
arithmetic or a geometric progression, etc.

Usually in a loan, there are several commercial features. These commercial features
modify the cost of a loan.

For example, if we do not take into account the commercial features, the most
expensive loan is when the instalments vary forming a geometric progression, then the
loan with an annuity amortization schedule and finally interest amortization schedule.

But if we take into account the commercial features, the cheapest loan is when the
instalments vary forming a geometric progression, then the loan with an annuity
amortization schedule and finally interest amortization schedule.

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4.- Financial value of a loan

Sometimes, when there is a financial transaction (loan), one of the parties wants to
transfer it to a third person (legal or physical). In this case, the market conditions
(interest rates) may have changed.

Therefore, the transference of the outstanding balance has to be made taking into
account the new market conditions.

•The outstanding balance (mathematical reserve) at point s is:

n r
Cs  
r  s 1
ar  (1  i h ) 1
h  s 1

• The financial value at point s is:

n r
Vs  
r  s 1
ar  (1  i 'h ) 1
h  s 1

Vs, is the financial value of the loan at s (a moment in time): it is the difference
between the future payments and repayments but valued with a new financial
law (F’(t,p)→i’) that reflects the new market conditions.
22
Example

Determine the financial value of a loan granted three years ago with the following
conditions:

Co=Є10,000,000

n= 10 years

i= 8%

The instalments vary forming a geometric progression of common ratio 5%.

The new market interest rate is 6%

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