Financial Mathematics. Unit 8. Loans with predetermined rates.
UNIT 8: LOANS WITH PREDETERMINED RATES
8.1. Bullet loan. Interest-only loan (“Préstamo americano”, in Spanish)
A1 0 ; A2 0 ; ... ; An 1 0; and An C 0
1. Cs? C 0 C1 ... C n 1 C n 0
2. as? Recall from unit 7: as = As + Is and Is = Cs-1 ꞏ is
Therefore, the periodic payments of a bullet loan, with its specific characteristics are:
a1 = A1 + I1 = 0 + C0 ꞏ i1 = C0 ꞏ i1
a2 = A2 + I2 = 0 + C1 ꞏ i2 = C0 ꞏ i2
a3 = A3 + I3 = 0 + C2 ꞏ i3 = C0 ꞏ i3
.
.
.
an-1 = An-1 + In-1 = 0 + Cn-2 ꞏ in-1 = C0 ꞏ in-1 and the payment for the last period will be :
an = An + In = C0 + Cn-1 ꞏ in = C0 + C0 ꞏ in
In general:
as I s C0 is s 1, 2,, n 1 ; an I n An C0 in C0 C0 1 in
If the interest rates are constant for the whole loan then:
i1 = i2 = …….= in → a1 = a2 = …….= an-1 = I = C0 ꞏ i ; an = I + A = C0 ꞏ i + C0
Graphically:
a1
a2
an
C1=C0
C2=C0 Cn-1=C0
C0
t0 t1 t2 tn-1 tn
i1 i2 in Cn=0
Example 8.1
Find the periodic amount to be paid at the end of each month to pay off a bullet loan of
EUR20,000 in 5 years. The annual nominal interest rate is 4.25%
1
Financial Mathematics. Unit 8. Loans with predetermined rates.
8.2. Level-payment fixed-rate loan. Equal payments and constant interest rate
(“Préstamo francés, in Spanish).
a1 a2 ... an a
i1 i2 ... in i
Timeline:
C0 Cs-1 Cs
a a ……. a a a ……… a a
t0 t1 t2 ts-1 ts ts+1 tn-1 tn
i
1. a or C0? Equation of equivalence:
C0
At t0: C0 a a n | i a
a n|i
At tn: C0 (1 i) a sn | i
n
2. Cs? Outstanding balance:
Usually, prospective method (since we know all the future payments and interest rates):
Cs F .IFs F .OFs a a n s | i
Or, alternatively, retrospective method:
Cs [Link] [Link] C0 (1 i ) s a ss | i
3. As? Recursive method:
C s C s 1 (1 i ) a
C s 1 C s (1 i ) a
C s C s 1 (C s 1 C s )(1 i )
As 1 As (1 i ) As A1 (1 i ) s 1
Hence, principal repayments vary in geometric progression with ratio (1 + i):
A2 A1 1 i
A3 A2 1 i A1 1 i
2
As As 1 1 i A1 1 i
s 1
A1? a1 I1 A1 C0 i A1 A1 a C0 i
4. Over the term of the loan, as the outstanding balance decreases, the interest portion of
each payment decreases and the principal repayment portion increases since the (total)
periodic payment remains constant. a I s As Cs 1 i As
2
Financial Mathematics. Unit 8. Loans with predetermined rates.
Example 8.2
A loan of $60,000 is being repaid with equal quarterly level payments at the end of each
quarter. The term of the loan is 3 years and the nominal interest rate is 4% convertible
quarterly. Obtain:
a) The quarterly payment.
b) The outstanding principal of the loan at one year and two months after the initial
date.
c) Decompose the sixth periodic payment into interest payment and the principal
repayment.
8.3. Constant principal repayments loan.
In this case since the principal repayment is constant, first we have to obtain that
constant amount. The periodic payments will be obtained summing up the interest
payment to the constant principal repayment previously obtained.
A1 A2 ... An A as I s A Cs 1 is A
1. A?
n
From the general case we know that C0 Ah A1 A2 A3 ... An . This equation is
h 1
valid for every loan. Therefore, in this particular case:
C0
C0 n A A
n
2. Ms?
s
M s Ah A1 A2 A3 ... As s A
h 1
3.
Cs?
Cs C0 M s C0 s A n A s A (n s ) A
n
Cs
h s 1
Ah As 1 As 2 As 3 ... An n s A
4. as?
as I s A Cs 1 is A
Example 8.3
Obtain the semi-annual periodic payments of a three-year loan of $15,000 with constant
principal repayments. The nominal interest rate convertible each semester is 4%.
3
Financial Mathematics. Unit 8. Loans with predetermined rates.
8.4. Other loans: Loans with fractional interest payments
They are compatible with any of the previous loans.
In loans with fractional interest payments the frequency of interest payments is higher
than the frequency of principal repayments, since the latter is performed with a single
payment at the end of the period.
Thus, in a loan with n periods with fractional interest payments of frequency m, there
are nxm total periodic payments where the m-1 first payments of each period only pay
the interest due and the mth payment includes both interest and principal repayment.
Accordingly, this issue should not be confused with loans with monthly, quarterly, or
semi-annual periodic payments, where principal repayment is made, like interest
payment, monthly, quarterly or semi-annually.
Fractional interest payment often occurs in loans where the principal repayments are
known in advance (predetermined), either constant or not; and it is compatible with both
fixed and indexed interest rates.
Example 8.4
Let us consider a loan of €30.000 for 3 years with a 6% nominal interest rate and semi-
annual interest payment. Principal repayments are made annually and they are €5,000
for the first year, €10,000 for the second year and €15,000 for the last year.
Obtain the periodic payments and the outstanding balance for all periods.
A1 A2 A3 C 0
2 j (2) 0, 06
j (2)
0, 06 i 0, 03
2 2
30,000
a0.5 a1 a1.5 a2 a2.5 a3
_____________________
0 0.5 1 1.5 2 2 .5 3
First year:
a 0 ,5 I 0 ,5 C 0 i 2 30.000 0,03 900
a1 I1 A1 C0.5 i 2 A1 C0 i 2 A1 900 5.000 5.900
C1 C 0 A1 A2 A3 25.000
Second year:
a1,5 I 1,5 C1 i 2 25 .000 0,03 750
a 2 I 2 A2 C1 i 2 A2 750 10.000 10.750
C2 C1 A2 A3 15.000
Third year:
a 2 ,5 I 2 ,5 C 2 i 2 15.000 0,03 450
a3 I3 A3 C2 i 2 A3 450 15.000 15.450
C3 0