Financial Mathematics with a Computational

Approach
Lecture Week-8: Loan Amortization Methods

Dr. Muhammad Sheraz

Institute of Business Administration Karachi

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 1 / 95
 Topics Covered This Week

The Amortization Method of Loan Payment and General Cases

Level Payment Amortized Loans

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 2 / 95
 Loan Payment and Methods

When a loan is being repaid by a series of payments, the total of

all payments must repay:
(a) The original amount of the loan (the principal)
(b) Plus provide interest on the loan
Each loan payment can typically be separated into two
components:
(i) Interest paid
(ii) Principal paid
There are several ways to set up a loan repayment scheme
The most common method is the amortization method

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 3 / 95
 Example-1: Illustration of Amortized Loan
Payment

Loan amount: $1,000

Interest rate: 10% per year
Payment schedule:
$200 at end of Year 1
$500 at end of Year 2
Final payment at end of Year 3

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 4 / 95
 Year 1 Calculation

Before payment: 1, 000 × (1.10) = 1, 100

After payment: 1, 100 − 200 = 900 (outstanding balance)

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 5 / 95
 Year 2 Calculation

Before payment: 900 × (1.10) = 990

After payment: 990 − 500 = 490 (outstanding balance)

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 6 / 95
 Year 3 Calculation

Before payment: 490 × (1.10) = 539

Final payment required: $539

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 7 / 95
 Defining Feature of Amortized Loans

Each payment follows this process:

Previous outstanding balance is accumulated with interest to
current payment point
New payment is subtracted from that accumulated amount
Result is the new outstanding balance

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 8 / 95
 Separation into Interest and Principal

First Payment ($200 at Year 1):

Interest due: 1, 000 × 0.10 = 100

Principal repaid: 200 − 100 = 100
Outstanding balance: 1, 000 − 100 = 900

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 9 / 95
 Separation into Interest and Principal

Second Payment ($500 at Year 2):

Interest due: 900 × 0.10 = 90

Principal repaid: 500 − 90 = 410
Outstanding balance: 900 − 410 = 490

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 10 / 95
 Separation into Interest and Principal

Third Payment ($539 at Year 3):

Interest due: 490 × 0.10 = 49

Principal repaid: 539 − 49 = 490
Outstanding balance: 490 − 490 = 0

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 11 / 95
 Mathematical Formulation

Outstanding balance updates:

1000 × (1.10) − 200 = 900

900 × (1.10) − 500 = 490
490 × (1.10) − 539 = 0

Combined expression:

1000 × (1.10)3 − 200 × (1.10)2 − 500 × (1.10) − 539 = 0

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 12 / 95
 Mathematical Formulation (cont.)

1
Using discount factor v = 1.10
:

1000 = 200v + 500v 2 + 539v 3

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 13 / 95
 Key Principle

The original loan amount equals the present value

of the loan payments using the loan interest rate.

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 14 / 95
 Interest Analysis

Total payments: 200 + 500 + 539 = 1, 239

Original principal: $1,000
Total interest paid: 1, 239 − 1, 000 = 239
Interest breakdown by payment:
Year 1: $100
Year 2: $90
Year 3: $49
Total interest: 100 + 90 + 49 = 239

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 15 / 95
 Definition 1: Amortized Loan

An amortized loan of amount L made at time 0 at periodic interest

rate i and to be repaid by n payments of amounts K1 , K2 , . . . , Kn at
times 1, 2, . . . , n satisfies:
1
L = K1 × v + K2 × v 2 + · · · + Kn × v n where v =
1+i

The loan amount equals the present value of all loan payments.
This is the fundamental equation of loan amortization.

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 16 / 95
 Example-2: Formulation

If a loan is repaid one interest period later:

Total payment: L × (1 + i) = L + L × i
Components:
L: repayment of original principal
L × i: payment of interest due
Just before payment: accumulated amount owed is L × (1 + i)
Payment reduces amount owed to zero

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 17 / 95
 Outstanding Balance Calculation

When payment K1 is less than L(1 + i), loan is not fully repaid.
Outstanding balance after first payment:

OB1 = L × (1 + i) − K1

Alternative formulation:

OB1 = L × (1 + i) − K1 = L − (K1 − L × i)

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 18 / 95
 Payment Allocation

L × i: accrued interest on original principal

K1 − L × i: amount applied to reduce principal
Outstanding balance = initial balance minus principal repaid

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 19 / 95
 General Amortization Process

Denote initial loan amount as OB0 (outstanding balance at time 0)

After first period:

Accumulated amount: OB0 × (1 + i)

After payment K1 :OB1 = OB0 × (1 + i) − K1

Alternative formulation:

OB1 = OB0 − (K1 − OB0 × i)

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 20 / 95
 Payment Components

I1 = OB0 × i (interest paid)

PR1 = K1 − I1 (principal repaid)
OB1 = OB0 − PR1 (new outstanding balance)

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 21 / 95
 Second Payment Period

Accumulated balance: OB1 × (1 + i)

After payment K2 : OB2 = OB1 × (1 + i) − K2
Alternative formulations:

OB2 = OB1 × (1 + i) − K2
= OB1 − (K2 − OB1 × i)
= OB1 − (K2 − I2 )
= OB1 − PR2

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 22 / 95
 Second Payment Components

I2 = OB1 × i (interest due)

PR2 = K2 − I2 (principal repaid)

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 23 / 95
 General Period t to t + 1

Outstanding balance just after t th payment: OBt

During next period, balance accumulates to: OBt × (1 + i)
After (t + 1)st payment Kt+1 :

OBt+1 = OBt × (1 + i) − Kt+1

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 24 / 95
 General Period (Alternative Forms)

OBt+1 = OBt − (Kt+1 − OBt × i)

= OBt − (Kt+1 − It+1 )
= OBt − PRt+1

Payment components for period t + 1:

It+1 = OBt × i (interest due)

PRt+1 = Kt+1 − It+1 (principal repaid)

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 25 / 95
 Final Payment and Completion

Process continues until nth (final) payment

Final outstanding balance: OBn = OBn−1 × (1 + i) − Kn = 0
Each payment decomposes into:
Interest portion: pays accrued interest since last payment
Principal portion: repays part of the outstanding principal

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 26 / 95
 Amortization Method Case 1: Variable Payment
Amortized Loan

Example-3
A loan of amount $1000 at a nominal annual interest rate of 12%
compounded monthly is repaid by 6 monthly payments, starting one
month after the loan is made. The first three payments are amount
X each and the final three payments are amount 2X each.

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 27 / 95
 Solution: Example-3

Nominal annual rate = 12% compounded monthly

Monthly interest rate = 12%
12
= 1% = 0.01
Number of payments = 6
Payment pattern: X , X , X , 2X , 2X , 2X

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 28 / 95
 Step 1: Solve for X using equation of value

The present value of payments equals the loan amount:

1000 = X · a3|0.01 + 2X · v 3 · a3|0.01

Where:
−3
a3|0.01 = 1−(1.01)
0.01
= 2.940985
3 −3
v = (1.01) = 0.970590

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 29 / 95
 Equation of Value Concept

The equation of value says:

The present value (PV) of all payments (discounted to time 0) must
equal the loan amount at time 0.
This is based on the principle that, at the loan inception, the money
received (loan principal) should be equivalent in value to the future
repayments, discounted at the loan interest rate.

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 30 / 95
 Present Value Construction

To get PV at time 0, first find PV at time 3 (start of 4th payment),

then discount to time 0.
At time 3, the last 3 payments are 2X , 2X , 2X at times 4, 5, 6
relative to time 0, but in time-3 value.

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 31 / 95
 Solving for X

Substituting values:

1000 = X · 2.940985 + 2X · 0.970590 · 2.940985

1000 = X · 2.940985 + 2X · 2.854977
1000 = X · 2.940985 + X · 5.709954
1000 = X · 8.650939
1000
X = = 115.61
8.650939
2X = 231.21

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 32 / 95
 Step 2: Construct Amortization Schedule

Month Payment Interest Principal Outstanding

t Kt It PRt Balance OBt
0 – – – 1000.00
1 115.61 10.00 105.61 894.39
2 115.61 8.94 106.67 787.72
3 115.61 7.88 107.73 679.99
4 231.21 6.80 224.41 455.58
5 231.21 4.56 226.65 228.93
6 231.21 2.29 228.92 -0.01

Table: Amortization Schedule

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 33 / 95
 Construction of the Amortization Table

The amortization table is constructed using the following principles:

Column Definitions
Month (t): Time period (0 to 6)
Payment (Kt ): Total payment made at time t
Interest (It ): Interest portion = Outstanding balance ×
monthly rate
Principal (PRt ): Principal portion = Payment − Interest
Outstanding Balance (OBt ): Remaining loan balance after
payment

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 34 / 95
 Construction of the Table

Initialization (Month 0)

OB0 = 1000.00

Month 1 Calculation

I1 = OB0 × 0.01 = 1000.00 × 0.01 = 10.00

PR1 = K1 − I1 = 115.61 − 10.00 = 105.61
OB1 = OB0 − PR1 = 1000.00 − 105.61 = 894.39

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 35 / 95
 Month 2 Calculation

I2 = OB1 × 0.01 = 894.39 × 0.01 = 8.94

PR2 = K2 − I2 = 115.61 − 8.94 = 106.67
OB2 = OB1 − PR2 = 894.39 − 106.67 = 787.72

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 36 / 95
 Month 3 Calculation

I3 = OB2 × 0.01 = 787.72 × 0.01 = 7.88

PR3 = K3 − I3 = 115.61 − 7.88 = 107.73
OB3 = OB2 − PR3 = 787.72 − 107.73 = 679.99

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 37 / 95
 Month 4 Calculation

I4 = OB3 × 0.01 = 679.99 × 0.01 = 6.80

PR4 = K4 − I4 = 231.21 − 6.80 = 224.41
OB4 = OB3 − PR4 = 679.99 − 224.41 = 455.58

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 38 / 95
 Month 5 Calculation

I5 = OB4 × 0.01 = 455.58 × 0.01 = 4.56

PR5 = K5 − I5 = 231.21 − 4.56 = 226.65
OB5 = OB4 − PR5 = 455.58 − 226.65 = 228.93

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 39 / 95
 Month 6 Calculation

I6 = OB5 × 0.01 = 228.93 × 0.01 = 2.29

PR6 = K6 − I6 = 231.21 − 2.29 = 228.92
OB6 = OB5 − PR6 = 228.93 − 228.92 = 0.01 (rounding error)

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 40 / 95
 Step 3: Analysis of Results

Total payments = 3 × 115.61 + 3 × 231.21 = 1040.46

Total interest =
10.00 + 8.94 + 7.88 + 6.80 + 4.56 + 2.29 = 40.47
Total principal = 1040.46 − 40.47 = 999.99
The final outstanding balance of -0.01 is due to rounding error
In practice, the final payment would be adjusted to 231.22 to
reduce OB6 to exactly zero

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 41 / 95
 Key Observations

This example demonstrates amortization with variable payments

The equation of value accounts for the changing payment
amounts
Interest portion decreases over time as principal is repaid
Principal portion increases over time
Rounding errors can accumulate in practical calculations

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 42 / 95
 Retrospective Method for Outstanding Balance

The retrospective method provides an alternative way to calculate the

outstanding balance at any point during the amortization process.

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 43 / 95
 General Formulation

Following the amortization process for a general n-payment loan:

OB1 = OB0 × (1 + i) − K1
OB2 = OB1 × (1 + i) − K2 = OB0 × (1 + i)2 − K1 × (1
OB3 = OB2 × (1 + i) − K3 = OB0 × (1 + i)3 − K1 × (1
−K2 × (1 + i) − K3
..
.
OBt = OB0 × (1 + i)t − K1 × (1 + i)t−1 − K2 × (1 + i)

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 44 / 95
 Retrospective Method Formula

The general relationship is:

OBt = OB0 × (1 + i)t − K1 × (1 + i)t−1 − K2 × (1 + i)t−2 − · · · − Kt

This is called the retrospective method because it looks back at

the history of the loan:
OB0 × (1 + i)t : Original loan accumulated to time t
K1 × (1 + i)t−1 + K2 × (1 + i)t−2 + · · · + Kt : Accumulated value
of all payments made up to time t
Outstanding balance = Accumulated original loan -
Accumulated payments

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 45 / 95
 Accumulation to Time t

OB0 × (1 + i)t − K1 × (1 + i)t−1 − K2 × (1 + i)t−2 − · · · − Kt = OBt

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 46 / 95
 Example Application

Using the previous example with:

OB0 = 1000
i = 0.01 monthly
First three payments: K1 = K2 = K3 = 115.61
Outstanding balance after third payment:

OB3 = 1000 × (1.01)3 − 115.61 × (1.01)2 − 115.61 × (1.01) − 115.61

= 1000 × 1.030301 − 115.61 × 1.0201 − 115.61 × 1.01 − 115.61
= 1030.30 − 117.92 − 116.77 − 115.61
= 679.99

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 47 / 95
 Alternative Calculation

Alternative calculation using annuity accumulation:

OB3 = 1000×(1.01)3 −115.61×s3|0.01 = 1030.30−115.61×3.0301 = 679

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 48 / 95
 Connection to Fundamental Equation

When the loan is completely repaid at time n:

OBn = OB0 ×(1+i)n −K1 ×(1+i)n−1 −K2 ×(1+i)n−2 −· · ·−Kn = 0

Multiplying both sides by v n and rearranging:

OB0 = K1 v + K2 v 2 + · · · + Kn v n (3.1)

This confirms the fundamental equation: The original loan

amount equals the present value of all loan payments.

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 49 / 95
 Key Insights

The retrospective method provides a direct way to calculate

outstanding balance at any point
It emphasizes the time value of money by accumulating both
loan and payments
It’s particularly useful when payment amounts vary
It demonstrates the mathematical consistency of the
amortization process
The final equation confirms the fundamental principle of loan
amortization

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 50 / 95
 Prospective Form of the Outstanding Balance

The retrospective method formulates the outstanding balance by

looking backward at the history of the loan. There is an equivalent
alternative approach called the prospective method.

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 51 / 95
 Derivation of Prospective Formula

Starting with the retrospective form:

OBt = OB0 × (1 + i)t − K1 × (1 + i)t−1 − K2 × (1 + i)t−2 − · · · − Kt

Substitute the fundamental equation

OB0 = K1 v + K2 v 2 + · · · + Kn v n into the retrospective form:

OBt = K1 v + K2 v 2 + · · · + Kt v t + Kt+1 v t+1 + · · · + Kn v n × (1 + i)t

 

− K1 (1 + i)t−1 − K2 (1 + i)t−2 − · · · − Kt−1 (1 + i) − Kt

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 52 / 95
 Prospective Formula Result

After algebraic simplification, this reduces to:

OBt = Kt+1 v + Kt+2 v 2 + · · · + Kn v n−t (3.10)

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 53 / 95
 Interpretation of Prospective Method

The prospective form shows that:

OBt equals the present value at time t of all remaining payments
The remaining payments are those from time t + 1 onward
The payment just made at time t is NOT included
This method looks forward to future payments rather than
backward to past transactions
Key Insight: Just as the original loan amount is the present value of
all loan payments, the outstanding balance at any point in time is the
present value of the remaining payments.

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 54 / 95
 Example-4: Application
Using our previous Example-3 with:
Payments 4, 5, and 6: K4 = K5 = K6 = 231.21
Monthly interest rate: i = 0.01
Calculate OB3 (outstanding balance after 3rd payment)
Using the prospective method:

OB3 = 231.21v + 231.21v 2 + 231.21v 3

= 231.21 · a3|0.01
1 − (1.01)−3
= 231.21 ×
0.01
= 231.21 × 2.940985
= 679.98

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 55 / 95
 Equivalence of Methods

Retrospective and prospective methods are algebraically

equivalent
Retrospective: OBt = Accumulated original loan - Accumulated
payments
Prospective: OBt = Present value of remaining payments
Both methods should yield the same result (allowing for
rounding)
Choice of method depends on which is more convenient for
calculation

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 56 / 95
 Practical Considerations

Prospective method is often easier when payment amounts are

level
Retrospective method may be preferred when payment amounts
vary
Lenders typically use prospective method for mortgage
statements
Both methods reinforce the time value of money principle

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 57 / 95
 Amortization Method Case 2: Non-Level Interest
Rate

The amortization method can be extended to handle loans with

changing interest rates over time. Let:
i1 : interest rate for period 1 (time 0 to time 1)
i2 : interest rate for period 2 (time 1 to time 2)
it+1 : interest rate for period t + 1

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 58 / 95
 Non-Level Interest Rate Amortization

The amortization relationships become:

OB1 = OB0 × (1 + i1 ) − K1
= OB0 − (K1 − OB0 × i1 )
= OB0 − (K1 − I1 )
= OB0 − PR1

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 59 / 95
 General Period with Changing Rates

And in general for any period:

OBt+1 = OBt × (1 + it+1 ) − Kt+1

= OBt − (Kt+1 − OBt × it+1 )
= OBt − (Kt+1 − It+1 )
= OBt − PRt+1

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 60 / 95
 Key Points for Non-Level Interest Rates

The basic amortization structure remains the same

Interest rate changes affect the interest portion of each payment
Principal repayment calculation adapts to the current period’s
rate
Outstanding balance updates using the current period’s interest
rate

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 61 / 95
 Example-4: Non-Level Interest Rates

A loan of amount $1000 is repaid by 6 monthly payments, starting

one month after the loan is made.
Interest rate for first 3 months: 12% nominal annual
compounded monthly (1% monthly)
Interest rate for next 3 months: 6% nominal annual
compounded monthly (0.5% monthly)
First three payments: X each
Final three payments: 2X each

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 62 / 95
 Solution: Step 1

Step 1: Solve for X using equation of value

Monthly interest rates:
First 3 months: i1 = 0.12/12 = 0.01
Last 3 months: i2 = 0.06/12 = 0.005
Present value equation:
3
1000 = X · a3|0.01 + 2X · v0.01 · a3|0.005

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 63 / 95
 Calculate Components

Calculate components:

1 − (1.01)−3
a3|0.01 = = 2.940985
0.01
1 − (1.005)−3
a3|0.005 = = 2.970248
0.005
3
v0.01 = (1.01)−3 = 0.970590

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 64 / 95
 Substitute Values

Substitute values:

1000 = X · 2.940985 + 2X · 0.970590 · 2.970248

1000 = X · 2.940985 + 2X · 2.883882
1000 = X · 2.940985 + X · 5.767764
1000 = X · 8.708749
1000
X = = 114.85
8.708749
2X = 229.71

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 65 / 95
 Step 2: Construct Amortization Schedule

Month Payment Interest Principal Outstanding

t Kt It PRt Balance OBt
0 – – – 1000.00
1 114.85 10.00 104.85 895.15
2 114.85 8.95 105.90 789.25
3 114.85 7.89 106.96 682.29
4 229.71 3.41 226.30 455.99
5 229.71 2.28 227.43 228.56
6 229.71 1.14 228.57 -0.01

Table: Amortization Schedule with Changing Interest Rates

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 66 / 95
 Step 3: Verification and Analysis

Total payments = 3 × 114.85 + 3 × 229.71 = 1039.68

Total interest =
10.00 + 8.95 + 7.89 + 3.41 + 2.28 + 1.14 = 33.67
Total principal = 1039.68 − 33.67 = 1006.01 (rounding error
due to -0.01 final balance)
Notice the significant drop in interest payments after month 3
when rate decreases

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 67 / 95
 Comparison with Constant Rate Loan

With constant 12% rate: X = 115.61, total payments = 1040.46

With changing rates: X = 114.85, total payments = 1039.68
Lower payment amount due to reduced interest rate in later
periods
Borrower benefits from interest rate decrease

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 68 / 95
 Key Observations

The equation of value accounts for different interest rates in

different periods
Amortization schedule adapts to rate changes seamlessly
Lower interest rates in later periods reduce total interest paid
The fundamental principles of amortization remain valid with
changing rates

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 69 / 95
 Amortization with Level Payments of Principal

There are two main approaches to loan amortization:

Level Total Payments: The most common method where
each payment is the same total amount, but the allocation
between interest and principal changes over time.
Level Principal Payments: A less common approach where
the principal repayment amount is fixed for each payment, and
the total payment decreases over time as interest decreases.

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 70 / 95
 Level Total Payments Method

In the level total payments method:

Principal repayments increase systematically over time
Interest payments decrease over time
Total payment amount remains constant

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 71 / 95
 Example-5: Loan with Level Payments of Principal

A loan of $3000 at an effective quarterly interest rate of j = 0.02 is

amortized by means of 12 quarterly payments, beginning one quarter
after the loan is made. Each payment consists of a principal
repayment of $250 plus interest due on the previous quarter’s
outstanding balance.

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 72 / 95
 Solution: Given Parameters

Given Parameters:
Initial loan amount: L = OB0 = 3000
Quarterly interest rate: i = 0.02
Number of payments: n = 12
Level principal repayment: PR = 250 per quarter
Payments begin at time 1 (end of first quarter)

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 73 / 95
 Step 1: First Payment Calculation

Interest for first quarter: I1 = OB0 × i = 3000 × 0.02

= 60
Principal repayment: PR1 = 250
Total first payment: K1 = I1 + PR1 = 60 + 250
= 310
OB after first payment: OB1 = OB0 − PR1 = 3000 − 250
= 2750

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 74 / 95
 Step 2: Complete Amortization Schedule

Quarter Payment Interest Principal Outstanding

t Kt It PRt Balance OBt

0 – – – 3000.00
1 310.00 60.00 250.00 2750.00
2 305.00 55.00 250.00 2500.00
3 300.00 50.00 250.00 2250.00
4 295.00 45.00 250.00 2000.00
5 290.00 40.00 250.00 1750.00
6 285.00 35.00 250.00 1500.00
7 280.00 30.00 250.00 1250.00
8 275.00 25.00 250.00 1000.00
9 270.00 20.00 250.00 750.00
10 265.00 15.00 250.00 500.00
11 260.00 10.00 250.00 250.00
12 255.00 5.00 250.00 0.00

Table: Amortization Schedule with Level Principal Payments of $250

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 75 / 95
 Step 3: Mathematical Verification

Total Principal Repaid: 12 × 250 = 3000

Total Interest Paid:
60 + 55 + 50 + 45 + 40 + 35 + 30 + 25 + 20 + 15 + 10 + 5 = 390
Total Payments: 3000 + 390 = 3390
Payment Pattern: Payments decrease by $5 each quarter
(310, 305, 300, . . . , 255)
Interest Pattern: Interest decreases by $5 each quarter
(60, 55, 50, . . . , 5)
Balance Pattern: Outstanding balance decreases linearly by
$250 each quarter

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 76 / 95
 Step 4: General Formulas for Level Principal
Payments

For a loan with level principal payments:

L
PRt = (constant principal repayment)
n  t
OBt = L − t × PRt = L × 1 −
 n 
t −1
It = OBt−1 × i = L × i × 1 −
n
 
L t −1
Kt = PRt + It = + L × i × 1 −
n n

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 77 / 95
 Step 5: Comparison with Level Total Payments

Level Principal Payments Level Total Payments

• Principal repayment constant • Total payment constant
• Interest decreases over time • Interest decreases over time
• Total payment decreases over time • Principal repayment increases over time
• Outstanding balance decreases linearly • Outstanding balance decreases non-
linearly
• Easier to calculate • Requires annuity formulas
• Higher initial payments • Constant cash flow for borrower

Table: Comparison of Amortization Methods

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 78 / 95
 Key Observations

Level principal payments create a predictable, linear reduction in

debt
The method is mathematically simpler than level total payments
Borrowers pay more interest in the early periods compared to
later
This method is often used in commercial loans and bond sinking
funds
The total interest paid is the same regardless of method (for
same interest rate)

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 79 / 95
 Amortization of a Loan with Level Payments

When a loan is repaid with level payments, the amortization schedule

follows a systematic pattern. For a loan with payments beginning one
period after the loan is made and each payment of amount 1:
L = OB0 = an|i
K1 = K2 = · · · = Kn = 1

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 80 / 95
 Outstanding Balance Formulas

Prospective Form:

OBt = v + v 2 + · · · + v n−t = an−t|i

This is the present value of the remaining n − t payments.

Retrospective Form:

OBt = L × (1 + i)t − K × st|i

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 81 / 95
 OB Balance Formula Verification

Loan Amount (L = OB0 ): Initial balance at time 0

L = an|i

Payment (K ): Level payments

K1 = K2 = · · · = Kn = 1

Outstanding Balance (OBt ): Remaining balance after t-th

payment
Interest Rate: i per period

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 82 / 95
 Annuity Symbols Definition

Present Value Annuity

an−t|i = v + v 2 + · · · + v n−t
Present value of n − t payments of 1

Future Value Annuity

st|i = 1 + (1 + i) + (1 + i)2 + · · · + (1 + i)t−1
Accumulated value of t payments of 1

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 83 / 95
 Prospective Method

Intuitive Approach
“The outstanding balance equals the present value of remaining
payments”

OBt = v + v 2 + · · · + v n−t = an−t|i

Looks forward at future payments

Direct application of present value concept
Commonly used in practice

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 84 / 95
 Deriving Retrospective Method

Historical Approach
“Current balance equals accumulated loan amount minus
accumulated payments made”

1 Accumulated Loan Amount:

L × (1 + i)t

2 Accumulated Payments:

st|i = (1 + i)t−1 + (1 + i)t−2 + · · · + 1

3 Net Balance:
OBt = L × (1 + i)t − st|i

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 85 / 95
 Proving Equivalence
Proof.
Start with retrospective form:

OBt = L × (1 + i)t − st|i

Substitute L = an|i :

OBt = an|i × (1 + i)t − st|i

Use annuity identity:

an|i (1 + i)t = st|i + an−t|i

Substitute identity:
 
OBt = st|i + an−t|i − st|i
Dr. Muhammad Sheraz (Institute of BusinessFinancial
Administration
Mathematics
Karachi)
with a Computational Approach 86 / 95
 Understanding the Annuity Identity

an|i (1 + i)t = st|i + an−t|i

Left side: Value of all n payments accumulated to time t
Right side:
st|i : Value of first t payments (past payments)
an−t|i : Value of remaining n − t payments (future payments)

Time Payments Value at time t

1 to t Past st|i
t + 1 to n Future an−t|i

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 87 / 95
 Total Payment Analysis

Pn
Total payments: KT = j=1 Kj = n
Total interest:
n
X
IT = Ij = (1 − v n ) + (1 − v n−1 ) + · · · + (1 − v ) = n − an|i
j=1

Total principal repaid:

KT − IT = n − (n − an|i ) = an|i = L

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 88 / 95
 Principal Repayment Pattern

The principal repayments form a geometric sequence:

PR2 = v n−1 = v n × (1 + i) = PR1 × (1 + i)

PRt = v n−t+1 = v n × (1 + i)t−1 = PR1 × (1 + i)t−1

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 89 / 95
 Example-7: 30-Year Mortgage

A homebuyer borrows $250,000 to be repaid over a 30-year period

with level monthly payments beginning one month after the loan is
made. The interest rate is 9% nominal annual compounded monthly.

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 90 / 95
 Solution: Step 1 - Calculate Monthly Payment

Monthly interest rate: i = 0.09

12
= 0.0075
Number of payments: n = 30 × 12 = 360
Payment K satisfies: K × a360|0.0075 = 250, 000
Calculate payment:
250, 000 250, 000
K= = 1−(1.0075)−360
= 2, 011.556542
a360|0.0075
0.0075

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 91 / 95
 Part (a): First Year Analysis
Outstanding balance after 12 months:

OB12 = 2, 011.556542 × a348|0.0075 = 248, 292.0073

Principal repaid in first year:

250, 000 − 248, 292.0073 = 1, 707.9927

Total payments in first year:

12 × 2, 011.556542 = 24, 138.6785

Interest paid in first year:

24, 138.6785 − 1, 707.9927 = 22, 430.6858

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 92 / 95
 Part (b): 30th Year Analysis
Outstanding balance after 29 years (348 months):

OB348 = 2, 011.556542 × a12|0.0075 = 23, 001.9734

Principal repaid in 30th year:

23, 001.9734 (entire remaining balance)

Total payments in 30th year:

12 × 2, 011.556542 = 24, 138.6785

Interest paid in 30th year:

24, 138.6785 − 23, 001.9734 = 1, 136.7051

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 93 / 95
 Key Observations

In early years, most of the payment goes toward interest

In later years, most of the payment goes toward principal
Principal repayments grow geometrically by factor (1 + i)
Total interest over 30 years:
360 × 2, 011.556542 − 250, 000 = 474, 160.35
The systematic pattern makes level payment amortization
predictable

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 94 / 95
 Summary

Amortization method systematically repays loan principal plus

interest
Two equivalent approaches: retrospective and prospective
Level payments vs level principal payments
Principal repayments grow geometrically in level payment
method
Changing interest rates can be accommodated in amortization
Understanding these concepts is crucial for financial planning
and analysis

Dr. Muhammad Sheraz (Institute of BusinessFinancial

Administration
Mathematics
Karachi)
with a Computational Approach 95 / 95