MA 2511 Fundamentals of Actuarial Mathematics

Lecture Note 3

Loan Repayment
What is loan?
Generally speaking, a loan is a contract between lender and
borrower in which the borrower receives money from the lender
and promises to repay the loan by a series of payments
(repayments) made in the future.

[ ]
( 了

O ε 5000

T 辽 3T

0
3
L 1000000
=

)
⑳
Lxc

1 / 80
Other basic terminologies about loan
1. (Interest] - The amount charged to borrower for borrowing
the money. There are two di!erent ways to calculate the
interest charged. ↓
↭ Compound interest: It is commonly adopted in many long-term
一

loans such as mortgage loan. The interest charged over the next
一

payment period depends on the outstanding balance at the last

payment date.
↭ Simple interest (Flat rate loan): It is sometimes adopted in
一

short-term loan and the interest charged depends on initial loan

一

principal.
(*Note: In this chapter, we will focus on the loan with the interest
is calculated based on compound interest.)
2. Repayment Schedule - Specify how does the loan be repaid
↭ Amortization method - cPayment is made periodically.] Normally,
part of the payment is paid for interest and the remaining is paid
for principal.
↭ Sinking fund method - ⑯ Pay interest charged periodically了 and the
loan principal L is paid at the last repayment date.
2 / 80
Basic theories and notations about amortized loan
We consider an amortized loan of amount θ L made at current
time (say, time 0 ) and to be repaid by 0 n payments of amount
P1 , P2 , . . . , Pn (where Pi > 0 ) made at times t1 , t2 , . . . , tn
(where t1 < t2 < · · · < tn ) respectively.
We would like to study the following issues:
↭ Relationship between the loan amountθ L and the payments
P1 , P2 , · · · , Pn .
一

This allows us to calculate various quantities involved in the loan

such as repayment amount Pi , loan term, interest rate of the loan
etc..
↭ [Decomposition of repayment:了 Interest due and Principal repaid.

1. [Outstanding balance of the loan了

When k th payment is made at time tk and the loan is not fully
repaid, the unpaid balance is called outstanding balance of the
loan at time tk . We denote this by OLBk .
One can observe that OLB0 = L and OLBn = 0.
一

3 / 80
 dPn

七一
←←
pdiedstPe
— -——

s
城
—
↓
。 - …

知
⑳⑲ ,跟
C
λ

ist periid 71 :
.
M

ti □ ⑫
ndpeniod
2
)
oLB , x ( 闻

th period )
OUBKIX Hi ( - ]
Σ

OLBn
Calculation of outstanding balance
We assume that the unpaid balance of the loan grows
according to an accumulation function a(t), t → 0. Then the
outstanding balance at k th payment date can be computed
inductively as follows:
↭ Given the outstanding balance OLBk at time tk , one can calculate
OLBk+1 as follows:
∅ ↭ At (k + 1)th payment date, the loan balance grows to
! "
□
OLBk a(t k+1 )
a(tk ) . 些OLB OLBn 0
,
=

↭ After the payment Pk+1 is paid, the outstanding balance drops to

# $ θ
a (tk+1 )
口 OLBk+1 = OLBk ↑□Pk+1 , k = 0, 1, . . . , n ↑ 1 θ
a (tk )
By applying the above recursive formula repeatedly, we deduce
that # $
□
↑
OLB j
k=j→1
= OLBj→1 口
a (tj )
a (tj→1 )
↑ Pj
% # $ &# $
一

曰
k=j→2 a (tj→1 ) a (tj )
= OLBj→2 ↑ Pj→1 ↑ Pj
a (tj→2 ) a (tj→1 )
4 / 80
 .
# $ # $
ot
a (tj ) a (tj )
= OLBj→2 ↑ Pj→1 ↑ Pj
Pf- atsYactjn )
y
a (tj→2 ) a (tj→1 ) -

# $ # $ # $
k=j→3 a (tj ) a (tj ) a (tj )
= · · · = OLB0 ↑ P1 ↑ P2 ↑ · · · ↑□θPj
a (t0 ) a (t1 ) a (t2 )
% # $ ∵
# $ &
a (tj ) a (tj )
= θ
e
OLB0 =L
La (tj ) ↑ P1 + P2 + · · · + Pj · · · · · · (↓)
θ a (t1 ) a (t2 )
Y FV of cash inflow
∝

a
Er of lstrepay attj
↭ The first term represents the future value of the loan of ourflow
amount at time tj
↭ The second term represents the future value of paid
repayments at time tj .
Hence, we deduce the following fact:
(Fact 1: 了 The outstanding balance of the loan at j th repayment
(OLBj ) is
↓ ↓
   
future value of sum of future value of
OLBj =  loan amount L  ↑  all paid repayments 
一

at time tj at time tj
一 一
5 / 80
 Relationship between the loan principal L and
repayments P i

口盆
By taking j = n and OLBn = 0 in equation (↓), we get
% # $ # $ &
δ OLB = La (t ) ↑ P a (tn ) + P a (tn ) + · · · + P
+ ,- .n n 1
a (t1 )
2
a (t2 )
n
=0
# $ # $ # $
“ a (t
一n ) a (tn ) a (tn )
一 一

↔ La (tn ) = P1 + P2 + · · · + Pn
a (t1 ) a (t2 ) a (tn )
P1 P2 Pn
↔L= + + ··· + . . . . . . (↓↓) 「

a (t1 ) a (t2 ) a (tn ) 一

+ ,- .
present value of repayments
at time 0

Hence, we deduce the following fact that we used at lot before.

(Fact 2:] The initial loan amount L is the present value of all
一

future repayments P1 , P2 , . . . , Pn at time 0 .

一

6 / 80
Remark: Another approach in calculating outstanding balance
Recall from fact 1 that the outstanding balance OLBj is
computed as
j
/ a (tj )
OLBj = ⑨
La (tj )
+ ,- .
↑ Pi
⇌

i=1
a (ti )
future value of + ,- .
loan amount L future value
of paid payments

This method is called cretrospective method了 since the

calculation is based one payment paid in the past.
7 / 80
 Using fact 2 (or equation (→→ ) ), one can rewrite OLBj as
! "

繼门冊
j n a (tj )
.θ
n Pi a(t )
OLBj = i=1 a(ti ) a (tj ) ↑ i=1 Pi a(tji ) = i=j+1 Pi
a (ti )=
+ ,- .

州劑⇌— —
value of Pi
at time tj
≈

L -
aitj
)
=Profrepaymeatattj ↓
a a

点區 ) Pi

Lactj)
-

到 piatacej )
θ
"
=

jjtl
Pi
altiYaolj ) =0 <
B

Here, (OLB j Jcan be expressed as the present value of all future

(unpaid) repayments at e
一

←
j th repayment date. This approach is
called prospective method.
8 / 80
 1

↓
-
12
- ↑35 . ↑45 ↑x
——
—

+ 0 % 1 %
 L∞

Example 1 An amortized loan of amount e $1200 made today

is completely repaid by three payments $350, $450 and $X一 一 一

made at the end of 6th month, 12th month and 18th month
一
一
一

respectively. The loan charges interest at an annual nominal

θ convertible monthly.
一

interest rate of 12%

一

(a) Calculate X .
(b) Calculate the outstanding balances of the loan at the end
of 6th month (denoted by OLB1 ) and 12th month (denoted
一 一

by OLB2 ) respectively.
Solution
(a) Firstly, the accumulation function of the loan is seen to be
! "12t
i (m) =0.12
m=12 0
0.12
a(t) = 1+ = (1.01)12t .
012 一

Using the fact 2 (i.e. present value of all payments equal the loan
principal), we have

9 / 80
 ≈ 1200 =
350
+
450
+
X
a(0.5) a(1) a(1.5)
→ 1200 = 350(1.01)→6 + 450(1.01)→12 + X (1.01)→18
→冖
X = 563.3041
一

(b) Using retrospective method, the required outstanding balances,

denoted by OLB1 and OLB2 respectively, can be computed as
*

uBz
OLB1 =1200a(0.5) ↑ 350 = 1200(1.01)6 ↑ 350 ↓ 冖

凸口一间
923.8242一

OLB2 =1200a(1) ↑ 350

a(1)
↑ 450 =
o <Br
, -

450
一
a(0.5)
= 1200(1.01)12 ↑ 350(1.01)6 ↑ 450 ↓ □
530.658

Remark of Example 1
Alternatively, one can compute the outstanding balances in (b)
using prospective method (i.e. the outstanding balance at k th
payment date is the present value of all unpaid payments at
that time). That is,
10 / 80
 ti = 0 5
.

a(0.5)
a(0.5) 450 563.3041
□
OLB1 = 450
一河 a(1) -
+X
a(1.5)
=
(1.01) 6
+
(1.01)12
= 923.8242

□ OLB = X a(1) = 563.3041 = 530.658

—2 a(1.5) (1.01)6
一

Using the information and result obtained in Example 1, one

can construct the following
1 amortization table for this loan:

…
σ
一
M =

Lxaco 5]
.

92z -≈≈
t

. 5)
=
o .

∞ 了一 = θ
一
一

一
门
一

→
i θ
「

一
「

11 / 80
2. Breakdown of repayment: Interest due and Principal
repaid
We observe from the amortization table in Example 1 that
only part of the payment is used to repay the principal (or
一
一 一

outstanding balance). It is because the unpaid balance

generates additional interest over time. I 12}Z ~|
1
= 200} bxi
a =

350 73 - =
277
/ 200
-
27 } =
92}
口 ≈

In an amortized loan, the payment is first used to repay the

一

cinterestgenerated,by the outstanding balance since the last

payment date. This amount is called interest due and is
一

denoted by Ik , k = 0, 1, 2, . . ..
一

The remaining part of the payment (if any) will be used to

repay the principal of the loan. This amount is called (principal
repaid 了and is denoted by PRk .
一
12 / 80
 PR ↑ Pc↑ s
'
↑ 址雄 ①。↑
tt
止

,
层

↑
— 修- — ,
—1
—
—

+ 40t , thts 1 -
x
n
↑ ,
LBley '
Calculation of Ik and PRk
Suppose that the loan is prepaid by the payments
P1 , P2 , . . . , Pn made at t1 , t2 , . . . , tn respectively, the interest
… 一 一

due and principal repaid are given by

上

口口
Ik = OLBk→1
a (tk )
a (t )
→ OLBk→1
! "# $
=冖 OLBk→1 i[tk→1 ,tk ] ,
"# k→1 $ balance (at time tk→1 )
一

!
balance (at time tk ) OLBK =
OLBK )
-
~

PBK

□
PRk = Pk → Ik (or PRk = OLBk→1 → OLBk ) .
The breakdown of each payment in Example 1 is summarized
as follows 276 .

17
“

I 2w0
.

PRs
I20wXi ( 了
退
=
qa多 82
∵, ÷
.

←
92z 82 zq3 . .

←
.

(In this table, Ik is calculated by OLBk→1 ↑ (1.01)6 → OLBk→1 .) 13 / 80

Amortized loan with level payments
We consider an amortized loan which lender and borrower first decides
!the term? (or tenor) of the loan and calculate the amount of each
repayment given the loan term. This type of loan is adopted in mortgage
loan. We shall examine how to develop an amortized schedule for this
loan (e.g. determine the repayment amount, outstanding balance,
interest due, principal repaid etc.).
Given the loan term, we let θ n be the number of payments required to
repay the loan completely. To facilitate the analysis, we impose the
assumptions:
↭ The payments are made periodically (for example, every month,
一

every year). We assume that the payments are made at time

T , 2T , . . . , nT , where 0
T is the time length between two
consecutive payments (payment period).
↭ Amount of each payment is fixed and constant (i.e. level payment).
一

↭ The e!ective interest rate over each payment period (i.e.

[(k → 1)T , kT ]) is constant and equalse
一
i, i.e. i[(k→1)T ,kT ] = i for all
k = 1, 2, . . . , n.
(*Note: This assumption is valid for compound interest
scheme.) 14 / 80
Determination of repayment amount: Application of annuity
theory
We let θX be the amount of each payment. We note that the
present value of all payments made at future times must
match the loan principal L (see Fact 2). On the other hand,
the series of payments is seen to be an level annuity-immediate
that pays X at the end of each payment period (i.e.
[(k → 1)T , kT ]). Using the result established in annuity theory
(see Chapter 2), we deduce that

℃
-學
“
器
Xa =L↓X =
n̄|i
! "# $ a
L
n̄|i
=
Li
1 → (1 + i)→n
PV of
payments

Determination of outstanding balance

Using similar method, one can compute the outstanding
balances of the loan at di!erent payment dates.
↭ Using retrospective method (see Fact 1), the outstanding
balance at k th (k ↔ n) payment date is
15 / 80
 L↑ x↑ x↑ ↑x ↑ x ↑ x
"
x
x
↓
L-11

uMOT 3 新莎
'

t 2
T CJ个CaBT WT

ltisk - NKJ 1 T E1 T -

np
y
: ,
,

LICltigk - -

-
y
- Fltiy
ti ) k
[
1^- (ti) 州 —

述)—1 μ

=
t —

(_—

—
utiyn
-

stigharn
=

y
t- tig -
-
ta kT
=

! " ! "

只囧曰
future value of L future value of first k
OLBk = →
at time kT payments at time kT
= La(kT ) → Xsk̄|i gkli
! "
Li (1 + i)k → 1
= L(1 + i)k →
1 → (1 + i)→n i
! " ! "

→ θ
k
k
(1 + i) → 1 1 → (1 + i)→(n→k)
= L(1 + i) → L =L
—
1 → (1 + i)→n 1 → (1 + i)→n
—

↭ Alternatively, one can use prospective method and obtain the same
answer. That is,
! "
value of remaining (n → k)
OLBk =
一
payments at time kT
一
! "
1 → (1 + i)→(n→k)
=0 Xan→k|i = X
⇌ i
! " ! "
Li 1 → (1 + i)→(n→k) 1 → (1 + i)→(n→k)
= = L .
1 → (1 + i)→n i 1 → (1 + i)→n
一

16 / 80
OLB >

豳品
↑

Nx

1
DL ↑x

—十

t o T rE 8 =
4 .
Example 2 Ls
A 2-year loan of amount $14, 950 is repaid by θ8(= 4 → 2)
quarterly payments e
一 一

X made at the end of each quarter. The

一

first payment is made three month after the loan is made. The
loan charges interest at annual nominal interest rate 15.8%
一

convertible continuously.
一

Calculate X .
Solution
The accumulation function of the loan is
冖
i=0.158
a(t) = e it = e 0.158t . The e!ective interest rate over a
一

H
month,μ denoted by I , is given by

quearter ! " ! "

□
a k4 ↑ a k→1 0.158
I = ! k→1 " 4 = e 4 ↑ 1 = 0.04029
a 4
一

0 .

0054
Using fact 2, one can establish that
Xa = 14950 ↓ X (6.724676) = 14950 ↓←
鿪 8|I X ↔ 2223.1554.
一

↑ 17 / 80
Remark of Example 2 (Minor adjustment in regular payment
and final payment)
In practice, the repayment amount is rounded to nearest 10 θ
cent (or cent) for feasibility. As a result, one needs to adjust
一

the amount of final payment in order that the loan can be

repaid completely. Take Example 2 as an example, the
adjustment can be done as follows:
Step 1: Round up/down the repayment amount X to nearest 10 cent.
That is, ←

≈X = 2223.1554 ↔ 口
2223.2
Step 2: Adjust the amount of final repayment. We let Y be the amount
of final repayment. Then Y should be chosen such that

□ Xa7|I +
OY
a(2)
= 14950
I =0.04029
↓ 2223.2(5.995617) + Ye →0.158(2) = 14950
一
2222.8 2223 1554
↓ Y = 2222.78 ↔ □< .
.

The amount of last payment is adjusted to be θ

$2222.8 (instead of
2222.78).
18 / 80
 ↑x 222 } ?
=
.

↑Y
-

Tddd
—+LH

t - 0 T 2+ 3
T IT 8P
.

4 ↓
Another remark of Example 2 (Interest due v.s. principal
repaid in amortized loan)
One can study the interest due and principal repaid of each
payment by working out the corresponding amortization table:
一

(For simplicity, we take unadjusted amount X = 2223.1554 )

[xi ( )
(
一
℃ — ∞

( ∞ 一

L 月 9 一

19 / 80
 一

≈ 一

↭ We observe from the above table that the interest due is

smaller for later repayment. That is, larger proportion of
the payment is used to repay the principal.
↭ It is because the interest due in the next payment date
depends on the (outstanding balance) in the last payment
date ( Ik = OLBk→1 I[ k→1 , k ] = OLBk→1 I ). When the
4 4
outstanding balance is getting smaller, the interest due
becomes smaller.

20 / 80
 2e ix ↑@

hhto ÷ or
— —

t τπ

仁如 。
Example 3 s
A loan of amount c$250, 000) is repaid by 120 monthly level
一

payments made at the end of each month. The loan charges凶

interest at annual nominal discount rate d (12) = 8.4% payable
一

monthly. ( → Note: In this example, the discount rate quoted is

just a reference that is used to calculate the interest charged
by the loan. The loan itself, however, is not a discounted loan.)
(a) Compute the outstanding balance at O 70th ⑮repayment date.
(b) Calculate the interest due and principal repaid at 70th
repayment date.
(c) Compute the total amount of interest paid throughout the
loan term.
Solution
(a) We first compute the amount of each repayment (denoted by X ).
The accumulation function of the loan is
! "→mt d (m) =0.084
d (m)
0 a(t) = 1 →
m
m=12
= (0.993)→12t , t ↑ 0.
→

21 / 80
The e!ective interest rate I over a payment period can be computed as
#k$ # $
a 12 → a k→1
θI = # $ 12
= (0.993)→1 → 1 = 0.007049
a k→1
12 ⇌
Using Fact 2, X must satisfy

Xa120|I = 250000 ↓ X (80.79655) = 250000 ↓←

≈ X ↔ 3094.192
Λ

Using retrospective method (prospective method is also OK), the

outstanding balance at 70th payment date is found to be

≈
! "

11
70
OLB70 = 250000a
12
→ ) Xs70|I
% &' (
% &' (
Future value of Future value of
loan principal paid payments

= 250000(0.993)→70 → 3094.192(90.0979)
= c130002.6”

22 / 80
(b) Firstly, the interest-due at 70th payment date is given by
) *

□
I70 = OLB69 I = I Xa120→69|I = 0.007049[3094.192(42.7139544)]
一

= 931.678

So the corresponding principal repaid is given by

θ
PR70 = X → I70 = 3091.192 → 931.678 ↔ 2159.514

(c) Recall the fact that sum of interest due and principal repaid is the
payment amount, so we have
↓ X ☆ ex 2

! " ! " ! "

Total amount of Total amount of Total amount of
interest due
+
principal repaid
=
e
120 payments
θ
! "
Total amount of
↓ +冖250000 = 120(3094.192)
interest due
! " π
Total amount of
↓ = 121303.04
interest due
一

23 / 80
 ↓

x ↑↑↑↑↑ ↑
~-

海
4- -

TT
-

H-
-

15T IGT
t oxsT-
λ
OLB16 s
6275 55
:

T =

4 。
 号
Example 4 Leo borrows an amount X for 6 years from a bank
and agree to repay the loan by 24(= 6 → 4) level payments
made at the end of each quarter. The loan charges interest at
annual nominal interest rate i (12) = 6.6% convertible monthly.
It is given that the outstanding balance at the end of←4th year
→
is $6275.55.
(a) Calculate the value of X .
(b) Calculate the interest due and principal repaid at 16th
payment date.
Solution (a) The accumulation function of the loan is
! "12t
a(t) = 1 + 0.066
一 12 = (1.0055)12t . Then the e!ective interest rate over
a payment period (3 months) is given by
! " ! "
I =
-
a n4 ↑ a n→1
!
a n→1
" 4
←
= · · · = (1.0055)3 ↑ 1 ↓ 0.01659092.

1 tilj
4
k 16
=
,
n 24
=

-
④ -
n
,

24 / 80
 We let Y be the amount of each repayment. Using prospective method,
one can express the outstanding balance at the end of 4th year (denoted
by OLB16 ) as
075 . $

- *

@ 16
↑
OLB = *
Ya = Ya
24→16|I 8|0.01659092 ↓曰
Y (7.4343089)

By setting OLB16 = 6275.55, we obtain←

一
Y ↓ 844.1336. Hence, one can
use fact 2 and deduce that

X = Ya24|I = 844.1336(19.665139) ↓0
∞ 16600

(b) The interest paid at 16th payment date (denoted by I16 ) can be
computed as

I16 = □
OLB15 I ↑
一
! "
=↳Ya24→15|I) (1.0055)3 ↑ 1 = 844.1336(8.2966597)(0.01659092)
↓ 116.1943
一

The principal repaid at 16th payment date (denoted by PR16 ) is given by

PR16 = Y ↑ I16 = 844.1336 ↑ 116.1943 ↓ 727.9393

一
~

25 / 80
 一一影
Px xx ”

…
—1 —1
…
—

ST 20
T
t 0 T 5 ZT ?

诬
PB 20
=
398 .
Example 5 (Harder, modified from #63 of Sample
Exam FM of SOA)
Mary takes out a loan from a bank today and she repays the
loan by e 42 monthly level repayments made at the end of each
month. The first repayment is made 1 month after today. The
bank charges interest at an annual nominal interest rate 6.55%
⇒→

convertible continuously.
一

It is given that the principal repaid of 20th payment is

$398.2278.
Calculate the total amount of interest paid on this loan.
=

Solution We let X be the amount of each payment. The accumulation

function of the loan is≈
a(t) = e 0.0655t , t → 0. So the e!ective interest rate
(denoted by I ) over a payment period is found to be
!n" ! "
↑ a n→1
0
a 12
□ = e 0.0655( 12 ) ↑ 1 ↓ 0.00547326
1
! " 12
I =
a n→1
12

26 / 80
 Using prospective method, the outstanding balance after 19th payment
(OLB19 ) is found to be θ
↓
I
Owumbenof remaining repayhent
OLB19 = Xa42→19|I = · · · ↓ 冖
21.5559X
一

Then the principal repaid at the 20th payment ( PR20 ) can be computed
as
)OUB19 O-

□ X ↑ [OLB19 (1 + I ) ↑ OLB19 ]←
PR20 = Ol = X ↑ I (21.5559X ) = 0.882019X
# $% &
interest due

Since (PR20 = 398.2278,了 then we have≈

X ↓ 451.4957. Using fact 2, the
一

loan principal can be computed as

□
L = Xa42|I = (451.4957)(37.43114332) ↓ e
16900

Hence, the total amount of interest paid is seen to be

42X
Interest paid = ⑥
42X
#$%& ↑ 16900
# $% & = 2062.8197
z 15
c = Xa4
total principal

Primiptal
Itat
payment
. inferese 27 / 80
 Another type of amortized loan with level payments
We consider another type of amortized loan with level
payments which the lender and borrower first decides the

⑧
amount of payment X and payment frequency and then
一

determine the term of the loan (i.e. number of repayments

required). This type of loan is used when the borrower has
(budget constraint.] Given the amount of each repayment θ X,
we let θ
n be minimum number of repayments required to repay
the loan completely.
Similar to the previous case, we impose the following
assumptions:
↭ The payments are made (periodically了 (for example, every month,
every year). We assume that the payments are made at time
T , 2T , . . . , nT , where T is the time length between two
consecutive payments (payment period).
↭ The e!ective interest rate over a payment period (i.e.
[(k ↑ 1)T , kT ]) is constant and equalsθ i, i.e. i[(k→1)T ,kT ] = i for all
k = 1, 2, . . . .n.
28 / 80
t
nHoTysiad
'n-
-

i的
L
PR 1 =⇒ OLB 1
< li =⇒
<O

I
=
L - ④
i

ifx :
=
X Li-
=
OLBo
-
PRs
2 OLB 0 =
L

X =⇒ PR2 X I2 < O
2 OLB 2
OLBi izLi
-
= =
:
L2
-

= ,

BR 3
,

= OLB 1 e

2 σ LB 2 L
)
.
Determination of θ
n (Loan term) Using fact 2 , we deduce that

回Xan̄|i = L → X
!
1 ↑ (1 + i)→n
"i
= L → (1 + i)→n = 1 ↑
α
Li
X

Tea
Li X
ln 1 ↑ X ln X →Li
→n=↑ = ,
⇌ ln(1 + i) ln(1 + i) ←
一

provided that X ↑ Li > 0 ↓ X > Li

Remark (why do we take O X ↑ Li > 0 ?)

i
If X ↑ Li ↔ 0, one can show that
OLBk = L(1 + i)k ↑ Xsk̄|i ↗ Xi > 0 for all positive integer k.
In other words, it is impossible for the borrower to repay the
loan completely within finite period of time.

□
X
ln X →Li
In general, ln(1+i) may not be an integer. Then the resulting
amortized schedule becomes infeasible. One need to adjust the
amount of payment (either regular payment or final payment)
in order to come up a feasible schedule.
29 / 80
Adjustment of final payment: ← Balloon payment1 and 上 Drop
一
payment
As an example, we consider an amortized loan of principal
amount 一 $120, 000. We assume that the loan is repaid by a
一

series of level payments made at the end of each month (the

first payment is made after 1 month). The amount of each
payment is ∞ $5000.
Suppose that the loan charges interest at annual nominal
interest rate e
一

12% convertible monthly, the e!ective interest

over a month can be computed as
!k" ! " 12t # $
a 12 ↑ a k→1 a(t)=(1+ 0.12
12 ) 0.12
i= ! " 12
= 1+ ↑ 1 =θ
0.01
a k→1
12
12
Hence, n can be obtained by solving the following equation:
5000
ln 5000→120000(0.01)

國哔
5000an̄|0.01 = 120000 → n = ↘口
27.5806754
ln(1 + 0.01)
30 / 80
We construct the following amortization schedule for this loan:

冖
一

四呂 ( 谈
冖
一

(*Note: The outstanding balance OLBk is calculated "using

retrospective method, i.e. OLBk = L(1 + i)k ↑ Xsk̄|i .
↭ We note that the loan cannot be repaid completely by θ27
payments (underpay) and there is a small outstanding
balance 2880.626.
一

↭ The outstanding balance becomes negative if the

borrower makes 28 payments of∞ $5000. In other word,
borrower overpays the loan.
一

31 / 80
In order to generate a feasible amortized schedule, one needs
to adjust the amount of final payment. There are two ways.
Method 1: Pay the outstanding balance only (instead of 5000)
at 28th payment date.

□ C 3
s 3 C ”

The final payment (highlighted in red) is called drop payment.

一

Method 2: Pay the outstanding balance together with the

regular payment at 27th payment date.

0 ( 3 ∝ 0

The final payment (highlighted in red) is called balloon

一

payment.
一 32 / 80
A summary of finding drop payment and balloon payment
'

(Normal case) (2
o 000 与 1000

Given the loan principal 0L and fixed repayment amount 0

X , one
can calculate the drop payment and balloon payment as
follows:

↓
*
←
T ①

[ ' M 2] =

28
M
=

θ ① c ,
-

5 θ
晕 Onok θ⑦ ; θ .

33 / 80
 ↑ ↑ ↑ x↑ zx

让您 *
1H
tuthtay
_

28
aGT T
2
IT
t 0 t 2
个 ZT -

↓x ↓x ↓x ↓ x ↓x ] x

fixL , , ) X
is n
i

xaali = 6 ⇒ x

i 23 fix L, x , i ⇒ n

Xawli =
l ⇒ n f inteyeb
General formula for balloon and drop payment (Optional)
的
X
ln
Given θ ↑ , we write 冖
X →Li
n = ln(1+i) 一
n = m + f , where m denotes the
一

integer part of n and f → [0, 1) denotes the fractional part of n.

一 一

For example, when cn = 27.58,I we have m = 27 and f = 0.58.

Using the definition of drop payment, we deduce that
! "
Drop payment = OLBm (1 + i) = L(1 + i)m ↑ Xsm̄|i (1 + i)
(1 + i)m+1 ↑ (1 + i)
= L(1 + i)m+1 ↑ X
i
1 ↑ (1 + i)→n (1 + i)m+1 ↑ (1 + i)
ne 2 J
=X (1 + i)m+1 ↑ X
i i m
=X
i ≈
1 + i ↑ (1 + i)m→n+1 n=m+f 1 + i ↑ (1 + i)1→f
= X
i few
In a similar fashion, one can deduce the formula for balloon
payment

f
mmnsisee
0
1 ↑ (1 + i)→f
Balloon payment = X + OLBm = · · · = X + X
~ i
.

34 / 80
 U≈ 27 89
.
fusl x - —uti
—
"

鬭
为 -
. 1
(
將 xa( T
) =

x
( ti5+
. ( Hi )

utighf
ti
-
X
Remark: Another method to find the drop payment and
balloon payment
Alternatively, one can compute the final payment using fact 2. (Here,
n =m+f )
↭ For the case when the final payment is a drop payment, m + 1
payments ( m regular payments of X + 1 drop payment of Y ) are
required to repay the loan. Using fact 2 , one can deduce that
Y a(kT )=(1+i)k ! "
Xam̄|i + =L → Y = (1 + i)m+1 L ↑ Xam̄|i
a((m + 1)T )
# $
m+1 1 ↑ (1 + i)→n 1 ↑ (1 + i)→m
→ Y = (1 + i) X ↑X = ···
i i
1 + i ↑ (1 + i)1→f
=X
i
↭ For the case when the final payment is a balloon payment, m
payments (m ↑ 1 regular payments of X + 1 balloon payment of Z )
are required. Using fact 2 again, we deduce that
Z 1 ↑ (1 + i)→f
Xam→1|i + = L → ··· → Z = X + X
a(mT ) i
Comment: This approach is more convenient since we don’t need OLBk . 35 / 80
Example 6 (Uniqueness of balloon payment)
A loan of amount / $6800 is repaid bye
m level payments made at
the end of every quarter. The first payment is made θ
一
3 months
after the loan is made. The amount of each payment is fixed
at θ
$300 except for the final payment ( mth payment), which is
~

a balloon payment. It is given that the loan charges interest at

一

annual nominal interest rate 10.8% convertible monthly.

一

(a) Calculate the amount of the balloon payment.

(b) Suppose that the loan term is fixed at∝8 years and other
terms (frequency of payments, amount of regular payment and
interest rate) remain unchanged, calculate the amount of final
1
一

payment, which will be paid at the end of 8th year ( 32th

一

payment).
Solution (a) The accumulation function of the loan is
% &12t
a(t) = 1 + 10.8
12 = (1.009)12t . So the e!ective interest rate over a
payment period ( 3 month) is

36 / 80
 ↑@ 351

中
↑ x↑ x↑ * EY 4

——
新北
—
—

"
七 0 τ
仿
+ ⑦
n =
35 : 76 .

X多00

↑x ↑x ↑x ↑x ↑x ↑)
←1
hhh-1-
-

p ZT4 T引τ Z厂
t 0 T2
 !k " ! "
a → a k→1
θ = (1.009)3 → 1 = 0.027244
4 4
i= ! k→1 "
a 4
Using fact 2 , we deduce that

器
300a = 6800 ↑ 300
n̄|i
1 → (1.027244)
0.027244
→n
= 6800
↑ (1.027244)→n = 0.38247548

鿪
ln 0.38247548
↑n=→ ↓ 35.76
ln 1.027244
Hence the loan can be paid by 34 regular payments of $300 plus a balloon
payment made at 35th payment date ( 35 payments in total). It remains
to calculate the amount of balloon payment Y . Using fact 2, we obtain

Q 44
Y
300a + = 6800
34|0.027244
.

a(35/4)
Y
↑ 300(21.9880928) + = 6800 ↑ 冖
Y ↓ 521.5438
(1.009)105 一

37 / 80
(b) When the loan term is fixed at 8 years, the loan must be repaid by 32
quarterly consists of 31 regular payments of $300 and 1 final payment of
Z . Using fact 2 again, we deduce that

*
ma
Z
300a31|0.027244 + = 6800
a(32/4)
Z
↑ 300(20.75216) + = 6800 ↑ Z ↓ 1357.473
(1.009)96 一

Remark
↭ The final payment θ
Z obtained in (b) is also a kind of balloon
一

payment since the payment contain both regular payment and the
一

remaining outstanding balance. So the balloon payment, in general,

is not unique.
↭ In reality, the amount of balloon payment can be significantly larger
一

than that of regular payment. To finance this balloon payment (if it

一

is too large), borrower may refinance the loan before the maturity
date (end date) of the loan.

38 / 80
 北↑ x↑ x↑ ↑ x ↑y

OTGsT 下年
.

—1 1 x
-…

+~
_

HT (ut 1 b }
-

λ 小
84 k Xe 4 2 k Z2
T ZZJ
(
=
.

, .
Example 7 (Problem 2 of Midterm Exam, 2017 Fall)
Peter borrows an amount θ $L from the bank today. He agrees
m level quarterly payments of amount o
to repay the loan by e $X
(made at the end of every quarter) plus a drop payment made
3 months after ×mth payment. The first payment is made 3
months after today.
↭ The loan charges interest at a quarterly e!ective interest
一

rate i = 3.15%.
一

↭ The outstanding balance at the end of 3rd year (just after

一

12th payment) is →
OLB12 = 61756.703 &
一

↭ The outstanding balance at the end of 6th year (just after

24th payment) is →
OLB24 = 29484.4. ←
一

Calculate the amount of drop payment.

(To calculate the drop payment, one needs to get the information about
the loan principal L and the repayment amount of each regular payment
X . We shall obtain this using the given conditions.)
39 / 80
Solution
The accumulation function of the loan can be expressed as
! "
k
a = (1 + i)k = (1.0315)k , k = 1, 2, . . .
4
(or a(t) = (1 + i)4t for t = 0, k4 , 2k4 , . . . )
Using the given information and applying retrospective
method, we get

口口
 ! "
 12

 La → Xs12|0.0315 = OLB12 = 61756.703

 4 ' () *
 ' () *
FV of paid
 FV of loan

 payments

 principle
 + ,
一
La 24
- 4
→ Xs24|0.0315 = OLB24 = □ 29484.4
12
L(1.0315) → Xs12|0.0315 = 61756.703
↑ θ
L(1.0315)24 → Xs24|0.0315 = 29484.4
40 / 80
Solving these 2 equations, we get
X s24|0.0315 →X s12|0.0315 (1.0315)12 = 61756.703(1.0315)12 → 29484.4
' () * ' () *
=35.08082 =14.31358
↑ lX = 4200]
L(1.0315)12 → 4200s12|0.0315 = 61756.703
↑”
L = 84000.
Next, we proceed to compute the drop payment. We first consider
! "
→
1 → (1.0315)→n
4200an̄|0.0315 = '84000
() * ↑ 4200 = 84000
一' () * 0.0315
L
Xan̄|i

↑□
n ↓ 32.0581
So the loan is repaid by 0 32 regular payments (of amount X = 4200 ) plus
a Ldrop payment, (of amount Y ). We get
Y
( 4200a
'
32|0.0315 +
() * ' (1 + 0.0315) 33 □
= 84000 ↑ Y ↓ 247.6888.
() *
Xa32 |i
Y /a( 33
4 )

41 / 80
 64
OLBX ()

↑ OLB ?

DL
= 55 k
k. ↑ 2 -
6k ↑26s
.
↑☆

eunorr
… )
:

]
—

⇌
*

=名 。

膨
Example 8 (A bit harder, Modified from #106 of Exam
FM sample exam)
At time 0 (current time), Mr. A borrows $55000 from a bank.
一 一

The bank charges interest at an annual nominal interest rate

of θ
12.12% convertible monthly. It is given that
↭ Mr. A repays the loan by θm monthly level payments of
→

一
$2600 and a drop payment of $X (X < 2600)1 month
一

after the mth payments.

↭ The first payment is madeθ 6 months after today.
Calculate 0X.
Solution
Step 1: Calculate the number of monthly payments of $2600
required (denoted by n ) to repay the loan completely. The
accumulation
! function
"mt of the loan#is
i (m) 12t
a(t) = 1 + m = (1+ 0.1212
12
= (1.0101)12t

42 / 80
The (monthly) e!ective interest rate over a payment period is
$k# $ #
a 12 → a k→1
= (1.0101)12( 12 ) → 1 =□
1
$ k→1 # 12
i= 0.0101
a 12

Using fact 2 and the fact that the first payment is made at the
end of 6th month, we deduce that
% &
t 1 → (1.0101)→n
2600an̄|0.0101 2600
= 55000 ↑ = 55000
a(5/12) (1.0101)5 0.0101
↓θ
ln 0.775336474
↑ (1.0101)→n = 0.775336474 ↑ n = → 25.3209
ln 1.0101 ⇌

(*Note: Remember that 2600an̄|0.0101 is just$the present

# value
th 5
of the repayments at the end of 5 month t = 12 .)
In other words, the loan can be repaid completely by0 m = 25
regular monthly payments of $2600 andθ
←
1 drop payment 1
th
month after 25 payment.
「

43 / 80
Step 2: Compute the drop payment Using retrospective method, the
outstanding balance atθ 25th payment date is seen to be
 &  
future value of sum of future value of
OLB 25 =  loan amount at  →  all paid repayments 

aTLhe
25 th payment date at 25th payment date
% & +
+
→ 2600s25 ++ 0.0101 s
5 25
= 55000a +
12 12
@
= 55000(1.0101)30 → 2600(28.27823) ↓ 828.8063.

Hence, the drop payment (paid at 26th payment date) can be computed
as
Drop payment = □
OLB25 (1 + i) = 828.8063(1.0101) = 837.1772 ε 2600
→

44 / 80
o “
2600
十
u
=

) )
斷
.
.
Several issues about amortized loan in real life
In this section, we shall study various aspects about amortized
loan happened in real life using the theories learned so far.
Amortized loan under varying interest rate (i.e. floating rate
一

loan)
For most of the mortgage loan in the market, the interest is
calculated based on some floating rates quoted in the market
τ
(instead of fixed rate). In Hong Kong, prime rate P了 and
(HIBOR H] (Hong Kong Inter-bank O!ered Rate) are two
popular floating rates used in mortgage loan.
Under the floating rate loan, the repayment amount is
calculated as follows:
↭ Given the current level of floating rate (P or H), the repayment
一

amount is calculated by assuming that the rate remains unchanged

一

throughout the entire loan term.

一

↭ If the interest rate has changed at some payment dates, the

一

repayment amount will be re-calculated based on the new interest

一

rate quoted and the outstanding balance at that time. 45 / 80

 L
…
ax " ↑x .

÷
☆
1 . -

-
t- xk +

t T 2
T
经十 T
0
↓x < ↓xa
口 2 xa
-

]
O OCB 至
4
 Example 9 (“Floating rate” Mortgage Loan)

X
Mr. A takes out a 20-year mortgage loan of $3, 680, 000
一

today. He agrees to repay the loan by 240(= 12 → 20) monthly

level payments (of amount X ) made at the end of each

.
month. The first payment is made at the end of 1st month.
The loan charges interest at an annual nominal interest rate of
@
(P ↑ 3.1%) convertible continuously, where P is prime rate.
一

The current level of prime rate is set to be 5%.

(a) Calculate the repayment amount 0
X.
一

(b) After ”
6 years (72 payments have been paid), the bank
decides to increase the prime rate toO
P = 7%. P 3 1% 3 9%
- =
. .

r
Suppose the bank decides to increase the amount of each
remaining payment toθ Y and the loan term remains
unchanged, find the value of Y .

46 / 80
 "
↑x ↑x Patx ty tiy
t+
-
- -
HH- 4

t 0 T IT IIT I 2I 7 BT 24]
←

X =
18445
毌
Solution (a) Recall the fact that the loan can be repaid by
240 monthly level payments of amount X (at an nominal
interest rate of 5% → 3.1% = 门 一
1.9%). The monthly e!ective
interest rate is computed as ∞
!n" ! "
→ a n→1
! n→1 " 12 冖
a 12 a(t)=e 0.019t 0.019( 1 )
I = 一

= e 12 → 1 ↑冖
0.001584459.
一

a 12 一
L

Using fact 2, X must山 satisfy

→
口
Xa240|I0 = 3680000 ↓ X (199.508451) = 3680000 ↓
一

λ
X ↑ 18445.334. ∅
一

(b) Next, we compute the outstanding balance of the

mortgage loan at the end of 6th year (just before the increase
in prime rate). Using retrospective method, one can deduce
that

口囧口
OLB72 = 3680000a(6) → Xs72|I θ

←
= 3680000e 0.019(6) → 18445.334(76.2041398) = 2718757.016
一
一

47 / 80
Starting fromθ 7th year, the new monthly e!ective interest rate
is
!n" ! "
a 12 → a n→1 一
e 12 → 1 ↑ →
a(t)=e 0.019(6) e 0.039(t→6) 0.039
θ
J= ! n→1 " 12
a 12
= 一
0.000325529.

The outstanding balance will be fully repaid by the remaining

CJOt
240→ 72 = 月168 repayments of amount Y . Using prospective
method, then Y satisfies
OLB72 = Ya168|J0↓ 2718757.016 = Y (129.2475) ↓←
≈ -
Y ↑ 21035.27
Remark of Example 9
↭ If the interest rate remains at P = 5%, the total interest
payment is
Interest = 240X → 3680000 = 746880.16
↭ If the interest rate increases to P = 7% after 6 years (and
remains unchanged in future), the total interest payment
becomes
Interest = 72X + 168Y → 3680000 = 1181989.4 48 / 80
Example 10 (Mortgage loan and stress test)
Recently, Hong Kong Monetary Authority has imposed various
measures for the restrictive mortgage lending in Hong Kong.
One restriction is known as stress test which requires that
↭ Given the current level of interest rate, the amount of
一

monthly repayment cannot exceed 50% of borrower’s

monthly income. aroillion IS, X 40 5 s
.

↭ If the interest rate is increased by 3%, the amount of

一

monthly repayment cannot exceed 60% of borrower’s

monthly income. x 以 :
& 0
: 6 S

(a) A borrower wishes to borrow an amount of c$3, 960, 000)

from the bank to buy a house. You are given that
↭ The monthly income of borrower is← $41, 000.
↭ The loan charges interest rate at an annual nominal
Λ

interest rate↳2.35% convertible monthly. The repayment

is made monthly.
∞
Find the minimum value of loan term (in year, integer valued)
such that the borrower can pass the stress test. 49 / 80
(b) Another borrower (with monthly income ($28, 000)了 wishes
to make a mortgage loan which charged the same interest as
in (a). Suppose that the maximum loan term← allowed is 30
years, calculate the maximum loan principal that the borrower
can borrow.
Solution
(a) Suppose that the loan term of the mortgage loan is 0n, then the
number of monthly repayment isθ 12n. Given the current level of interest
rate, the EIR over a payment period is
↓
!k" ! "
→ a k→1
" 12 = · · · ↑θ
a 12
i= ! 0.001958
⇌
a k→1
12

Then the monthly repayment amount is

→
1→(1+i)→n
an̄|i = i 7753.68
Xa12n|i = 3960000 ↓ X = . . . . . . (↔)
1 → (1.001958)→12n
π

50 / 80
 2.
% + 3%
35

If the interest rate is increased to □ 5.35%, the EIR over a payment period
a↑ ( 12
k
)→a↑ ( k→112 )
is given bye j= a↑ ( 12
= ··· ↑,0.004458. Then the new monthly
k
)
repayment amount is

T
17653.68
Ya12n|j = 3960000 ↓ Y = . . . . . . (↔↔)
1 → (1.004458)→12n
一

Based on the requirement of stress test, we have

#
□
曰 ≡
7753.68 $
X = 1→(1.001958) →12n ↗ 0.5(41000)
↓b
n ↘ 20.25
17653.68 ↓ n ↘ 23.69
Y = 1→(1.004458) →12n ↗ 0.6(41000) n ↘ 23.69
一

The minimum loan term required is e

24 years.

51 / 80
(b) We let 0 L be the loan principal of the mortgage loan. Then the
corresponding monthly repayment amounts are computed as

露四
- If the interest rate is 2.35%
L(0.001958)
Xa12n|i = L ↓ X =
1 → (1.001958)→12n
- If the interest rate is 5.35%

⇌
L(0.004458)
口
Ya12n|j = L ↓ Y =
1 → (1.004458)→12n
To pass the stress test, we require that
 

凸 □
 X = L(0.001958) ↗ 0.5(28000)  14000(1→(1.001958)→12n )
1→(1.001958)→12n L↗ 0.001958
L(0.004458) ↓ 16800(1→(1.004458)→12n )
 Y = 1→(1.004458) →12n ↗ 0.6(28000)
 L↗
0.004458

Note that n ↗ 30, this implies that

㉑ " ↓
( ! ! ")
→12(30) →12(30)
14000 1 → (1.001958) 16800 1 → (1.004458)
L ↗ min ,
0.001958 0.004458
↑ min(3614341, 3008656) = □
3008656.
52 / 80
Refinancing an amortized loan
In practice, the borrower may wish to refinance his loan by
either (1) replacing an existing loan by another loan (with
di!erent terms) o!ered by another financial institution or (2)
combining a series of loans by a single loan.
Example 11
Mary has two outstanding loans:
Loan 1: She needs to repay $1500.65 at the end of each month for 3
years. The loan charges interest at annual nominal interest rate of θ
一
一

一
18%
convertible monthly and 12th payment is made today.
Loan 2: She needs to repayθ $2750.68 at the end of each month for θ 4
e
years. The loan charges interest at annual nominal interest rate of 30%
convertible monthly and 24th payment is made today.

Mary decides to refinance her loan by borrowing an amount

一一
from another bank to repay two loans immediately. In other
words, she combine two loans into a single loan. She agrees to
repay the new loan by 上
24 monthly level payments (of
53 / 80
 tx

一鬭
↑ x x↑ x 1500 65
X =

tH
”
.

—
∵
Z!
,

了即部
↑ ↑e
{ ↑ hY
i

+ Y 275 0 68
'

1
-

11
—
.

T
48 T 28%
ET .

↑z ↑ z ↑e
— 1 此%
1
-
…
-

T 27 24T
②早
amount Z ). It is given that the bank charges interest at an
annual nominal interest rate of e24% convertible monthly.
(a) Calculate Z .
(b) Calculate the interest saved, if any, by refinancing the loan.
Solution (a) Using prospective method, the current outstanding
(1)
balances (OLB and OLB (2) ) of two loans are found to be
x
④
OLB (1) = 1500.65a36→12| 0.18 = 1500.65a24|0.015
12

= 1500.65(20.03040537) → 30058.6278.
一

OLB (2) = 2750.68a48→24| 0.3 = 2750.68a24|0.025

一
12

= 2750.68(17.88498583) → 冖
49195.8728.
一

So the loan principal of the new loan is seen to be

只冖L = OLB (1) + OLB (2) = 30058.6278 + 49195.8728 =冖

一
79254.5006
一

54 / 80
Using fact 2, Z must satisfy

回器
Za24| 0.24 = 79254.5006 ↑ Z (19.4606856) = 79254.5006
12

↑ Z → 4190.272
一

(b) The total amount of interest paid under original repayment schedule
(excluding those paid at earlier time) is

O (1)
⑥ (1)
J
I = [(36 ↓ 12)(1500.65) ↓ OLB + (48 ↓ 24)(2750.68) ↓ OLB ]
! "# $ ! "# $
(2)

interest paid (loan 1) interest paid (loan 2)

= 102031.92 ↓ 79254.5006 =□
22777.4194.

On the other hand, the amount of interest paid under new repayment
schedule (excluding those paid at earlier time) is

I (2) = 曰
θ 24Z ↓ 79254.5006)= 24(4190.272) ↓ 79254.5006
→ 21312.0274
一

Therefore, the amount of interest saved under the new plan is

…
I (1) ↓ I (2) = 22777.4194 ↓ 21312.0274 → □
1465.392
55 / 80
Example 12
Peter borrows an amount e L from bank A today and agrees to
repay the loan by 90 monthly level payments made (so the
一

loan term is 7.5 years). The first repayment is made 1 month

一

after today. It is given that the loan charges interest at an

annual nominal interest ratee 18% convertible monthly.
Immediately aftere 54th payment ( 36 payments remaining),
bank B o!ers a loan which charges interest at an annual
鿪
一

nominal interest rate 15% convertible monthly.

Knowing this, Peter decides to refinance his loan by borrowing
an amount from bank e B and repay the outstanding balance of
his original loanOLB
(in bank A) immediately. Peter repays the
new loan by 36 monthly level repayments.
一

Suppose that the amount of each repayment is 46.6836 lower

than the repayment amount of original loan, find the value of
0
L.
56 / 80
 *
恂
—
T 8T ↑x
,
↑
—
…
1-1-
x
⑭

↑
说

t 11 - T
< goT
18%
0
itn> →
☆ ,

OLB 54 d ↑y ↑ y
k
1
-
11 . 一

十即
马印

X -

Ye 46 6836 .
 Solution
We let X be the amount of each repayment under original loan. The
e!ective interest rate over a payment period is i = 0.18
12 = 0.015. X must

口
satisfy
L
Xa90|0.015 = L → X = ↑ 0.02032113L
49.20985452
Using prospective method, the outstanding balance of the loan just
before refinancing is
OLB54 = 3
口 X a90→54|0.015 = 0.56209636L
! "# $
=27.66068431

The e!ective interest rate of new loan over a payment period is

一
j = 0.15
一
12 = 0.0125 . We let Y be the amount of each repayment under
new loan. We have OLB54
↓
一Y a36|0.0125 = 0.56209636L →— Y ↑ 0.01948525L □
! "# $
=28.84726737

Since→
X ↓ Y = 46.6836, we have
一

(0.02032113 ↓ 0.01948525)L = 46.6836 → 曰

L ↑ 55849.64
∅
57 / 80
Loan repayment holiday
It allows the borrower to temporarily stop his repayments for a
short period of time (usually up to 12 months). It helps
一

borrower to ease his financial distress when there is an

unpredictable change in his financial situation (such as
unemployment, serious illness etc.). Although the borrower is
一

allowed to delay his repayments, he needs to repay a larger

amount in future since the interest continues to accumulate on
the loan during the holiday.
Example 13 At time 0, Peter borrows an amount of c$62980了
一

from a bank at a monthly e!ective interest rate ofθ

一

1.2%. He
agrees to repay the loan by c
60 monthly level payments
(amount X ) and the first payment is made 1 month from
today. After θ
2 years, Peter becomes unemployed. The bank
o!ers him a 6-month loan repayment holiday and Peter will
一

㉗
resume his repayment at the end of 31st month. However, the
bank will adjust the amount of each of 36 remaining payments
to Y . 58 / 80
 房莎刹系
77285
品

57 * 4
D Px $x ↑x

H
-
t 1 - -
-

↑
ut-hthHH
。 ,s 5 _
↑ T
6 …
七 0 十 个马 T
2

60 -

24 =
Z6
 (a) Calculate the value of Y → X .
(b) Calculate the increase in the total interest paid by taking
the repayment holiday.
Solution
(a) We first calculate the value of X . By fact 2, X must satisfy

≈
Xa = 62980 ↑ X (42.59643082) = 62980 ↑≈∞
60|0.012 X ↓ 1478.5276

Applying fact 2 on the new schedule again, Y satisfy

□ □ <
Ya36|0.012
Xa24|0.012 + ! " =口
62980
value at tr} T
0
a 24+6
的
12
1 2
a(t) = (1.012)12t , for t = 0,· ···
→ 12 12
Y (29.09325553)
↑X (20.74599914) + = 62980 θ
(1.012)30
↑一Y = 1588.2268.
一

(b) Using (a), the additional interest paid by taking the holiday is found
∞
to be Increase = (24X + 36Y → 62980) → (60X → 62980) ↓ 3949.1724.
59 / 80
Sinking fund method
We consider an amortized loan (with loan principal θ L) with the
following repayment scheme: The borrower only pays the
interest-due at each intermediate repayment date (i.e.
一一

T , 2T , . . . , (n → 1)T ) and repays the loan principal L (plus

一

the interest-due charged over the last period) at last

repayment date (i.e. nT ).
The borrower conly pays the interest-due)at each payment date
and make no (partial/full) repayment on the loan principal. So
that the outstanding balance of the loan remain to beθL.
To facilitate the final payment, the borrower will make
periodic deposits to a saving account/ investment fund at
each payment date and use the capital accumulated to settle
一

the final payment at the last repayment date.

一

This repayment strategy is known as sinking fund method

since an additional interest-bearing fund is involved in the
repayment process. The fund involved is called sinking fund.
60 / 80
A closer look on sinking fund method: A simple case
One can visualize the sinking fund method by the following
cash flow diagram. (*Here, i is constant e!ective interest rate
of the loan over a payment period)
OLR = L OLBE L
= ↓
θ
u O e

OO 0 0

61 / 80
Determination of Xi
It remains to find the amounts of deposit required in order to
accumulate at least L at the end date of the loan. We let a(t)
be the accumulation function of the sinking fund. Then Xi
Futare rake of all
must be chosen such that deposie
□□
a(nT ) a(nT ) a(nT )
X1 + X2 + · · · + Xn→1 + Xn ↔ L
a(T ) a(2T ) a((n → 1)T )
We assume that the sinking fund earns interest at e!ective
interest rate of j[(k→1)T ,kT ] =ej so that the accumulation
function of the fund is a(kT ) = (1 + j)k . Then the above
一

equation can be rewritten as

&

X1 (1 + j)n→1 + X2 (1 + j)n→2 + · · · + Xn→1 (1 + j) + Xn ↔ L

Suppose that the borrower makes level deposits, i.e.

台口
X1 = X2 = · · · = Xn = X , then we can deduce from annuity
theory that
L
Xsn̄|j ↔ L ↑ X ↔
sn̄|j 62 / 80
Sinking fund method versus Amortization method (with level
payments)
We would like to compare the 冖 e”ciencies between two loan
一

repayment methods, sinking fund method and amortization

method. This can be done by comparing the total amount 一

paid under each of these two methods.

θ
We let L be the loan principal and θ
i be the e!ective interest
rate of the loan over a payment period. We assume the
一

payment periods of two methods coincide and the loan term is

n payment periods.
Amortization method (with level payments)

喝
L
The amount of each payment is X = an̄|i . Then the total amount paid,
Ln
denoted by AP1 is AP1 = nX = an̄|i .
Sinking fund method

回
The amount of interest due paid at each payment is Li. On the other
L
hand, the amount of deposit (into sinking fund) is sn̄|j . Here, j denotes
the e!ective interest rate of the sinking fund over a payment period.
63 / 80
 titiyey .

rtijnict Ftijhctiyh
-

Ftiln
-
i

- -

-
-

-
 "
So the total
! amount " paid, denoted by AP2 , is given by
Hiy
_ )

%
冖
1 -( ti Sali =

L
AP2 = n Li + sn̄|j . One can show that anli =

□口
# $ % &
!
口口口凸
Ln L i 1
AP1 → AP2 = → n Li + = Ln → i →
an̄|i sn̄|j 一 1 → (1 + i)→n sn̄|j
% & % & % &

□ 口
→n
i(1 + i) 1 i 1 1 1
= Ln → = nL → = nL →
1 → (1 + i)→n sn̄|j (1 + i)n → 1 sn̄|j sn̄|i sn̄|j

sn̄|i is increasing with respect tof

Using the fact that □ i when
i > 0, we get
8
↭ AP1 < AP2 (i.e. AP1 → AP2 < 0 ) when i > j. Sali alj
7
3
亠
一
⇒Ysali 8
alj s
↭ AP1 = AP2 (i.e. AP1 → AP2 = 0 ) when i = j.
一
一

↭ AP1 > AP2 (i.e. AP1 → AP2 > 0 ) when i < j.

一

In simple word, the sinking fund is more e!cient (smaller

一

payment) when the return of sinking fund (proxied by j) is

higher than the interest rate charged by the loan (proxied by i).
一

64 / 80
Example 14 (Modified from #80 of Sample Exam FM
of SOA)
A 3-year loan of 20500 is made today. The loan charges
一
一

interest at an annual nominal interest rate of θ

一
i convertible
monthly.
一

The borrower is allowed to pay the interest due only at the end
of each month (The first payment is made 1 month after
一

today) and repay the principal after 3 years.

一

At each payment date, the borrower deposits an amount of 3 一

times the amount of that interest payment into a sinking fund.

一
一

The sinking fund earns interest at an annual nominal interest

rate of ←
0.75i convertible monthly.
Suppose that the sinking fund will accumulate the amount
needed to pay the loan principal at the end of 3rd year, find
the value of θ
i. 「

Solution
Note that the e!ective interest rate of the loan over a payment period (1
month) is seen to be i[ k→1 , k ] = · · · =0i
12 (left as exercise). 65 / 80
12 12
 L 20500
=

t ↑ lit rh↑ litIL

.
L

↓
「

— 十

— ……

t 0 4 2
个 影部马 6了 .

LI↓ BLiI ljI ↓ Lil

一1
一
「

也心个个
35 T ZGJ
 Since the outstanding balance of the loan is always 20500 at every
payment date, the interest due at each payment date is
! " L ! " Σ
i i
Ik = OLBk→1 1 + → OLBk→1 =c20500 ]
一

12 12
So the amount of deposit made at k th payment date (Dk ) is given by
# ! "$
i
Dk = □2
3Ik = 3 20500 =□ 5125i
12
a
Hence, the accumulated value of the sinking fund at the end of 3rd year
is computed as
% &36
1 + 0.75
12 i →1
Amount =□ 5125is36| 0.75 i = 5125i
e 12 0.75
i
. '! 12
(
"36
0.75
= 82000 1 + i →1
12
一

By setting Amount = 20500 (assuming the balance of the fund becomes

0 after the loan principal is repaid), we obtain
↓ '! "36 (
Erof 0.75
82000 1 + i → 1 = 20500 ↑←i ↓ 0.09948291
simtring fwaad
一
12
66 / 80
Example 15 (Harder, Modified from Problem 3.3.3 from
Broverman (2010))
The borrower of a loan of ←$25, 000 makes monthly interest
一

payments to the lender at an annual nominal interest rateθ i

convertible continuously and makes monthly deposits of θ
一

一
$560
→
into a sinking fund that earns interest at annual nominal
interest rate j = 0.09 convertible monthly.
一
一

The borrower will repay the loan principal once the balance of Λ

sinking fund reaches or exceeds ($25000., Suppose that the

一

total amount paid (interest due plus deposit) by the borrower 一

over the loan term is $29574.53, find the value of i.

⇌

Solution
Firstly, the e!ective interest rate of the loan over a payment period (one
month) can be computed as
%n& % &
a 12 → a n→112 a(t)=e it i
I = % n→1 & = e 12 → 1 . . . . . . (↔)
≈
a 12 ≡

67 / 80
 L 25000
↑ CI ↑ LI ↑LI
=

IL ↑ L江
.

t-
+~
- -
1 -
— 1 I : EIB in eack hroath .

T
七 0 个 2
T 个

2560 ↓560 ↓5b 25 G

0
0 .

H~+ 一
一
∆ n =

39 .

几T
七 0 T 了马厂 .

F式
Since the borrower pays the interest due at each payment date so that
the outstanding balance remains to be OLBk = 25000, hence the interest
due at k th payment date, denoted by Ik , can be computed as
! i "
□I k = OLB k→1 (1 + I ) → OLB k→1 = θ
25000I = 25000
-
e 12 → 1
一

—
a

We let n be the number of payments made on the loan. Since the loan
will be repaid completely once the accumulated value of the sinking fund
exceeds $25000, we have
(1.0075)n → 1
冖
560sn̄|
一
↑ 25000 ↓ 560
0.09
12 0.0075
↑ 25000 ↓ n ↑ 38.65056
一

So 0
39 payments will be needed. The corresponding accumulated value of
560s39|0.0075 = 25260.5754. 2 L 25000
the sinking fund at last payment date is 一 =

Since the total amount paid by the borrower is $29574.53, we deduce that

4
39I + 560(39) → (25260.5754 → 25000) = 29574.53
#$%&k # $% & # $% &
interest deposit balance (sinking fund)
! ! i
""
↓ 39 25000 e 12 → 1 = 7995.1054
↓←
i ↔ 0.098.
68 / 80
 Loans with other repayment patterns: Additional examples
In general, a loan can be repaid by any method/schedule
provided that it is agreed by both lender and borrower. In this
section, we shall study some loans which the repayment
schedule is di!erent from those studied before.
Example 16 (Amortized loan with level principal repaid)
Mr. A borrows an amount of ? $39600 from the bank and
agrees to repay loan by ⇌ 48 quarterly payments (the first
payment is made 3 months from today). The amount of each
payment is the 七一 interest due on outstanding balance plus a fixed
一

amount 老 X . It is given that the loan charges compound interest

(payable quarterly) at an annual e!ective interest rate of θ i.
It is given that the total amount of interest payment is
( $22799.7.了 Calculate θ i.
Solution
Note that the principal repaid at each payment period is X . Then X
0
must satisfy 48X = 39600 ↓ X = 825.
69 / 80
 地爬世
↑ ti -

e
nopxsgu
—- —
,
48 ↑

]
LB OLBoxacr) (li± x )
-

□
=

= L .

( 1HI) -
LI -
x
1 39 =

小
- ←X
→

Interest dur at 2
T ≈ OLB 1 '
I

OLBK →
L -
Kx

B
)
OUB, 2 (< )
] -
x 2 →
X
O< B48 =
0

L-

48 x ±
0

( x) ( 142) {-x) . S
- -

2 Xe 825 $
←
上 X X
- -

48
L ( (le)x
≈
X 府
-

第
-

48 40
(L ( -(k) x
—
48
- x (k11 ) 2 2
底 48 ( 忌
← ·

k =

48
-
.

=
底
底
We let OLBk be the outstanding balance just after k th payment. Then
OLBk satisfies
□
OLBk = OLBk→1 → 825 = OLBk→2 → 825(2) = · · ·

铣飚
= OLB0 → 825k = 39600 → 825k
We let I denotes the e!ective interest rate over a payment period ( 3
months) Then the amount of interest-due at k th payment date is Ir ≈ CI

Ik = →
I OLBk→1 (1 + I ) → OLBk→1 = (39600 → 825(k → 1))I Iz =
O( B
,
xI
→ ≈
(L x) I
~

Since the total amount of interest payments is $22799.7, so we have

48 48
LE XEk D } I
-

! !
Ik =22799.7 ↑ I (39600 → 825(k → 1)) = 22799.7

一旭旭
一

k=1 k=1
" #
↑ I 39600(48) → 825
(47 + 0)(48)
2
□∅
= 22799.7 ↑ I = 0.0235
$ %& '
=970200

The accumulation function of the loan is a(t) = (1 + i)t , t ↓ 0. Thus i

must satisfy
( ) ( )
a n4 → a n→1
□ □∞
1
( n→1 ) 4
0.0235 = I = = (1 + i) 4 → 1 ↑ i ↔ 0.097366
a 4
70 / 80
Example 17 (Payment amount is proportional to the
interest-due)
(*This example is modified from Example 5.4.5 of Vaaler &
Daniel (2009))

二
An investor borrows $32500 from the bank and agree to make
monthly payments that are 3.5 times of the interest due until
一
一

he can make a final payment of no more than → $6000 (including

interest due) to repay the outstanding balance of the loan.
一

It is given that
↭ the loan charges interest at an annual nominal interest
一

rate of ←
11.4% convertible monthly;
↭ the investor makes the final payment at the end of θnth
month.
(a) Compute the outstanding balance of the loan at the end of
2nd year.
(b) Calculate n and the total amount of interest paid in the
loan. 71 / 80
 ,↑ .5 ↑ 3 5 -e1 ↑E 32500
↓ L ↑ .52 3
z .
L=
3

十 +
→
—

一
一

— 一

七 θ e 印
LJJ WT EEGo
↓

↑↑
洲 Pm 。

的 $

{K 1} J
-

mT
Solution
(a) The monthly e!ective interest rate is [i = 0.114 ≈
12 = 0.0095.
For any m → 1, the amount of mth payment (made at the end of mth
month), denoted by Pm , is
< Bmy- i
□□
Pm = 3.5 ↑ [OLBm→1 (1 + i) ↓ OLBm→1 ] = e
3.5i ↑ OLBm→1

So the outstanding balance after mth payment can be expressed as

口
OLBm =OLBm→1 (1 + i) ↓ Pm = OLBm→1 (1 + i) ↓ □一
3.5i ↑ OLBm→1
= OLBm→1 (1 ↓ 2.5i) = 冖
OLBm→1 (0.97625)
一↑
Using the above recursive formula, we get

□
OLBm =OLBm→1 (0.97625) = [OLBm→2 (0.97625)] (0.97625)
= OLBm→2 (0.97625)2 = OLBm→3 (0.97625)3 = · · ·

Q θ=
= OLB0 (0.97625)m = 32500(0.97625) m 山

Therefore, the outstanding balance at the end of 2nd year is

n
OLB24 = 32500(0.97625)24 = 18253.5982
一

鼠 72 / 80
(b) Note that the outstanding balance just before the e
mth payment is
given by

bo
OLB before
= OLB
m (1 + i) = 32500(0.97625)
m→1 (1.0095) m→1

If the loan is repaid completely at the end of nth month, it must be that
OLBnbefore ↔ 6000. Hence, we deduce that

≈
32500(0.97625)n→1 (1.0095) ↔ 6000 ↗≈
3 n → 71.68127

So we have n = θ
72. The amount of final payment, denoted by F , is

F =□ before
OLB72 = 32500(0.97625)71 (1.0095) ↘ ∞
5954.208

The total amount paid by the investor (AP) can be computed as

cxo
71
! 71
!
AP = (
3.5i ↑ OLBm→1 +F = 3.5i
" #$ %
32500(0.97625)m→1 + 5954.208
m=1 m=1
Pm
71
+ 5954.258 ↘ ∞
1 ↓ (0.97625)
= 113750(0.0095) 43196.81.
1 ↓ 0.97625 d τ
Thus the amount of interest paid is一
43196.81 ↓ 32500 = 10696.81.
一

73 / 80
 π↑
s iP “ 号” r(
”

Te 单
≥

- "
—-
↑
…
- -
-

.
马 2T L =
98000
t … "

C
=
1 -
1 y
%

q
0
9
≈
-
Example 18 (Payments form a geometric progression)
(*This example is modified from #16 of sample exam FM of
SOA)
A loan of amount ($98000] is repaid by θ
32 quarterly payments
made at the end of each quarter. The amount of first
payment, which is made 3 months after today, is e P. Each
succeeding quarterly payment will be θ1% lower than the
previous payment. The loan charges interest at an annual
nominal interest rate←
8.52% convertible monthly.,
Calculate the outstanding balance of the loan (after payment)
at the end 6th year.
Solution
The accumulation
! "function of the loan is
12t
a(t) = 1 + 0.0852
12 = (1.0071) 12t
. So the e!ective interest rate over a
payment period is
! " ! "
a n4 → a n→1
I = ! " 4
= (1.0071)3 → 1 = 0.021452
a n→14
⇌

74 / 80
 One observes that the payments 的
! "
Pk = (1 → 0.01)k→1 P = (0.99)k→1 P
form a geometric series. Using fact朳2 , we obtain

·曰
# $32
1+(→0.01)
1→ 1+0.021452
P( ) = 98000 ↑ P ↓ 4873.0867
% &' ( → (→0.01)
0.021452
% &' (
progression .
I r

Using prospective method, the outstanding balance at the end of 6th

year (after 24th payment) can be computed-asy
ctt
=

p 1 24

Peep
.

-
K
)
滋 5 - ck
2

Pti ]  # $8 

θ
” 1+(→0.01)
! " 1 →
□
 
一
1+0.021452
OLB24 = (0.99)24 P ↔  ↓ 26950.077.
%一
&' ( 0.021452 → (→0.01) →
amount
(25 th payment )
/ 1+(→0.01) 8

1→( 1+0.021452 )
Caution: One has to be careful that OLB24 ↗= P ↔ 0.021452→(→0.01) .

75 / 80
 P01 ↑ Pt 71 Q

↑
北↑ P L= 31500
…
.
,

.
…
——
-

I 记T
I 2T
t 0
d

Pt
↑ptqs ↑ptlos 71 比 .

—十
… —
品

9T loT 11 T
Example 19 (Harder, Payments form an arithmetic
sequence)
Mr. B borrows∞ $31500 from a bank and agrees to repay the
loan by monthly payments made at the end of each month for
一

to
6 years. The loan
. charges interest at a annual nominal interest
*
rate of 13.8% convertible monthly. It is given that
-

↭ The amount of first payment, which is paid 1 month after

today, ise
P.
↭ The subsequent payments increase by Q each month.
It is given that the principal repaid at 10th payment date is
←
一

$179.385.了 .

Calculate the principal repaid at 30th repayment date.

Solution
One has to calculate the values of the unknowns P and Q. We need to
derive two equations governing P and Q. The monthly e!ective interest
rate of the loan is i = 0.138
12 = 0.0115. Using fact 2, P and Q should
satisfy
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IV of all paytmant .

(IP,Q a)72|0.0115 = 口
31500
-
θ % &
Q 72
→ P a72|0.0115 + a72|0.0115 ↑ = 31500
! "# $ 0.0115 (1.0115)72
=48.78334633
→→
48.78334633P + 1493.561486Q = 31500 . . . . . . (1) θ
一

Using prospective method, the outstanding balance at the 9th payment

aPV at 9 T of all fatume rreert
date is pay .

OC
OLB9 = (IP+9Q,Q a)(72→9)|0.0115 1
-
O -

% &
Q 63
= (P + 9Q) a63|0.0115 + a63|0.0115 ↑
! "# $ 0.0115 (1.0115)63
=44.64571833
=冖
44.64571833P + 1618.467227Q.
一

Since the principal repaid at 10th payment date is $179.385, so we have

θ
曰你
PR = 179.385 → (P + 9Q) ↑ (OLB (1 + i) ↑ OLB ) = 179.385
θ
10
! "# $ ! "# $
9 9
i
amount paid interest due
OLBq
'

→ 0.48657424P ↑ 9.61237311Q = 179.385

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 冖
→ P = 19.75520349Q + 368.6693325 . . . . . . (2) θ
一

By solving equations (1) and (2), we obtain Q = 5.5 and

一

P ↓ 477.322952. Note that the outstanding balance at 29th payment

一
date is
OLB29 = (IP+29Q,Q a)(72→29)|0.0115
一 % &
Q 43
= (P + 29Q) a43|0.0115 + a43|0.0115 ↑
! "# $ 0.0115 (1.0115)43
=33.77398925
↓←
25083.1601.

Therefore, the principal repaid at 30th payment date is [ OCBgx ) i

一
! "# $ !
冖
PR30 = (P + 29Q) ↑ (OLB 29 (1 + i) ↑ OLB29 )
"# $
amount paid interest due

= 636.822952 ↑ 288.4563482
↓ 3483.3666.
一

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Example 20
A 5 -year loan of amount $5500 can be repaid by one of the
following two methods.
Method 1: Equal quarterly payment (20 payments in total) made at the
end of each quarter. The first payment is made 3 months after today and
the interest is charged at a quarterly (3-month) e!ective interest rate of
4.6%.
Method 2: Quarterly payment made at the end of each quarter. Fixed
payment $275 plus the interest due on the outstanding balance is paid at
each payment. The interest is charged at a quarterly e!ective interest
rate of i.
Suppose the total interest paid under method 1 is same as
that of the total interest paid under method 2, calculate i.
Solution:
We first calculate the amount of each quarterly payment (denoted by X )
in method 1. Using fact 2, X must satisfy
Xa20|0.046 = 5500 → X ↓ 426.4905
Then the total interest paid under method 1 (I1 ) is found to be
I1 = 20X ↑ 5500 ↓ 3029.80963
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Next, we consider method 2. The outstanding balance at k th payment
date (OLBk ) can be computed as

OLBk =OLBk→1 (1 + i) ↑ [275 + OLBk→1 i] = OLBk→1 ↑ 275

= OLBk→2 ↑ 2(275) = · · · = OLB0 ↑ 275k = 5500 ↑ 275k

So the amount paid at k th payment date is seen to be

Amount k = 275 + OLB k→1 i = 275 + i(5500 ↑ 275(k ↑ 1)).

Then the total amount of interest paid can be computed as

' 20 ) 20
( (
I2 = [275 + i(5500 ↑ 275(k ↑ 1))] ↑ 5500 = [i(5500 ↑ 275(k ↑ 1))]
k=1 k=1
(5500 + 275)(20)
= i(5500 + 5225 + 4950 + · · · + 275) = i = 57750i
2
Since I1 = I2 , it follows that

3029.80963 = 57750i → i ↓ 0.052465

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