CHAPTER 4 AMORTIZATION OF

LOANS AND MORTGAGES

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OVERVIEW

4.1 Amortization of Loans

4.2 Mortgages

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DEFINITION

• People borrow money from financial institutions for various reasons:

start a business, go to school, purchase a care, renovate house...
• When we borrow money, we need to pay back the principal amount,
plus the interest acquired over the time of the loan
• The process of repaying a compound interest bearing loan by periodic
payments over a period of time is called amortization
• Amortization is the reduction of a debt through periodic repayments,
usually of equal amounts, over a period of time

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4.1 AMORTIZATIONS OF LOANS

• The amortization of a loan is the gradual reduction in the loan amount

through periodic repayments, usually of equal amounts, over a
predetermined length of time
• The time period set to repay the loan is called the amortization period
• Each repayment amount is first used to pay off the interest charged
during that period and the rest of the repayment amount is used to
reduce a portion of the principal of the loan
Þafter every repayment, the interest for the next period is calculated on
the reduced principal
• Amortization of loans is primarily considered as an ordinary annuity
because loan repayments are usually made at the end of the payment
period
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4.1 AMORTIZATIONS OF LOANS

• If the compounding period is equal to the payment period, the present

value of a loan (which is the principal) is calculated by the ordinary
simple annuity formula:
1 − (1 + 𝑖)!"
𝑃𝑉 = 𝑃𝑀𝑇 ∗
𝑖
• If the compounding period is not equal to the payment period, the
present value of the loan is calculated by substituting the equivalent
periodic interest rate per payment period (i2) for i in the above formula:
1 − (1 + 𝑖# )!"
𝑃𝑉 = 𝑃𝑀𝑇 ∗
𝑖

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AMORTIZATION SCHEDULE

• An amortization schedule is a detailed table that breaks down each

loan repayment amount into its interest portion and principal portion
• It also shows the amount of principal balance after each payment is
made
• An amortization schedule typically contains the following information:
• Payment number (or payment date)
• Payment amount (PMT)
• Interest portion of the payment amount (INT)
• Principal portion of the payment amount (PRN)
• Principal balance after each payment (BAL)

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AMORTIZATION SCHEDULE

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CONSTRUCTING AN AMORTIZATION SCHEDULE

• Step 1: Calculate the periodic interest rate (i)

• Step 2: Enter 0 as the first payment number in the first row and enter the original
loan amount, PV, as the principal balance in this row
• Step 3: Enter the periodic payment, PMT, in a new row against its respective
payment number. The periodic payment amount is generally a rounded amount.
Therefore, the final payment will be different from the other periodic payments as
it will carry the difference resulting from having rounded the previous payments
• Step 4: Enter the interest portion, INT, of the payment in the 3dr column. This is
the previous principal balance multiplied by the periodic interest rate
𝐼𝑁𝑇! = 𝐵𝐴𝐿!"# ∗ 𝑖
• Step 5: Enter the principal portion, PRN, of the payment in the 4th column. This is
the difference between the periodic payment amount and the interest portion
𝑃𝑅𝑁! = 𝑃𝑀𝑇 − 𝐼𝑁𝑇!

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CONSTRUCTING AN AMORTIZATION SCHEDULE

• Step 6: Enter the principal balance, BAL, in the 5th column. This is the difference
between the previous principal balance and the principal portion
𝐵𝐴𝐿! = 𝐵𝐴𝐿!"# − 𝑃𝑅𝑁!
• Step 7: Construct the remaining rows of the amortization schedule by performing
the calculations in Steps 3-6 until the final payment number, where the principal
balance will be zero
• Step 8: The final payment amount is calculated by adding the previous principal
balance and the interest charged on the previous principal balance
• Step 9: The last row contains all the totals and can be used to cross-check if the
calculations are correct:
𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑃𝑜𝑟𝑡𝑖𝑜𝑛 = 𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐿𝑜𝑎𝑛 𝐴𝑚𝑜𝑢𝑛𝑡

𝑇𝑜𝑡𝑎𝑙 𝐴𝑚𝑜𝑢𝑛𝑡 𝑃𝑎𝑖𝑑 = 𝑇𝑜𝑡𝑎𝑙 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑜𝑟𝑡𝑖𝑜𝑛 + 𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑃𝑜𝑟𝑡𝑖𝑜𝑛

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EXAMPLE

1. Sheila received a loan of $7500 at 9% compounded quarterly to

purchase a machine for her small business. She settled the loan by
making payments at the end of every three months for one year
a. Calculate the size of the payments
b. Construct an amortization schedule for the loan.
2. A manufacturer received a loan of $12,450 at 12% compounded
monthly to purchase equipment for his factory. He paid $3000 at the
end of every three months to settle the loan
a. Calculate the number of payments required
b. Construct an amortization schedule for the loan

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CALCULATING THE PRINCIPAL BALANCE

• It may be necessary to know the principal balance at an earlier time

than at the end of the loan period in order to settle the loan earlier or
make a partial repayment.
• This may be done by creating an amortization schedule and calculating
the principal balance at the required date or by directly using any of
the following methods:
• Prospective method
• Retrospective method

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PROSPECTIVE METHOD

• The principal balance at the focal date can be calculated by

determining the present value of all the outstanding payments on that
focal date
• This method is also known as the Present Value approach
𝐵𝐴𝐿$%&'( *'+, = 𝑃𝑉-.+/+'"01"2 3'45,"+/ %" +6, $%&'( *'+,

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RETROSPECTIVE METHOD

• The principal balance at the focal date can also be calculated by

deducting the future value of all the payments that have been made
until the focal date from the future value of the original loan amount
on the focal date
• This method is also known as the Future Value approach
𝐵𝐴𝐿$%&'( *'+, = 𝐹𝑉-7121"'( 8%'" − 𝐹𝑉3'45,"+/ 9'0, ."+1( +6, $%&'( *'+,

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EXAMPLES

1. Samantha received a loan of $25,000 at 4% compounded quarterly.

If the loan is amortized over ten years with payments made at the
end of every three months, what was the balance on her loan after
one year?
2. Andrew received a student loan of $45,000 at 6% compounded
monthly. If he has to repay $500 at the end of every month, what
was his principal balance at the end of two years?

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CALCULATING THE FINAL PAYMENT

The final payment can be calculated using either of the following

methods:
𝑃𝑀𝑇$1"'( = 𝐵𝐴𝐿:,;%7, $1"'( 3'45,"+ ∗ (1 + 𝑖)

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EXAMPLES

1. A loan of $750,000 at 12% compounded quarterly was settled by

making payments of $50,000 at the end of every six months
a. How many payments were required to settle the loan
b. What was the final payment on the loan?
2. Jias student loan had accumulated to $16,550 at the time of her
graduation. She had to start making payments of $273 at the
beginning of every month to settle the loan. The interest rate
charged was 6% compounded monthly
a. How many payments are required to settle the loan?
b. What is the final payment?

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CALCULATING THE INTEREST AND PRINCIPAL PORTIONS OF A PAYMENT

• In addition to determining the principal balance at a given time, it may

be necessary to determine the interest portion and principal portion of
a payment at any given time
• The interest portion at any given time is calculated on the previous principal
balance
• The principal portion can then be determined by subtracting the calculated
interest portion from the payment amount of the loan

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EXAMPLES
1. Clear Circuits Inc., an electrical contracting company, receives a loan of $130,000 at
6% compounded monthly to purchase some heavy equipment. It must make
payments of$5000 at the end of every month to settle the loan
a. What is the interest portion of the 19th payment?
b. What is the principal portion of the 19th payment?
2. Harold Consulting was paying $1500 at the end of every month to settle a loan of
$300,000 at 5.45% compounded quarterly
a. What was the total principal repaid in the 12th year?
b. What was the total interest paid in the 12th year?
3. Lucia received an $18,000 loan at 5.25% compounded monthly that was to be
repaid by payments of $500 made at the end of every month. Just when she
completed making the first 12 payments, she lost her job. However, her father
helped her pay the payments in the 2nd year of the loan
a. How much of the loan did her father settle?
b. How much interest did her father pay?
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CONSTRUCTING A PARTIAL AMORTIZATION SCHEDULE

• There may be instances when it is necessary to determine the

amortization details of a portion of the schedule, such as the last five
payments, the first five payments, or the interest and principal portions
of a particular payment
• It is for this reason that we determine all the payment details and
create a partial amortization schedule

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EXAMPLE

Clear Inc, an electrical contracting company, receives a loan of $130,000

at 6% compounded monthly to purchase some heavy equipment. It must
make payments of $5000 at the end of every month to settle the loan.
Construct the partial amortization details and schedule for the:
a. First two payments
b. Last two payments
c. Total payment made and interest paid

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4.2 MORTGAGES

• A mortgage is a loan that is issued by a financial lending institution to a

borrower in order to purchase real estate at a specific interest rate for
a specific time period
• As the principal amount of mortgages is high, the borrower generally
provides the lender with legal claim over the property (called
collateral), as per the mortgage contract, until the mortgage loan has
been completely amortized
• The amortization period is the length of time it takes to pay off the
entire amount borrowed based on the original mortgage contract
• The mortgage term is the length of time for which the mortgage
agreement (a specific interest rate) will be in effect, for example, 3.5%
compounded semi-annually for three years.
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TYPES OF MORTGAGES
• Lenders offer two types of mortgages: fixed rate and variable rate mortgages:
• Fixed rate mortgages have a fixed interest rate for a specific period of time
(mortgage term). When the term expires, the lender may renew the term for
another fixed period depending on the market interest rate
• Variable rate mortgages have rates that are dependent on changes in the
market. Mortgages with variable interest rates are also referred to as floating
rate mortgages.
• Fixed or variable rate mortgages can be open or closed:
• An open mortgage allows borrowers to prepay any amount at any time, close
the entire mortgage, or transfer from one lender to another without being
charged an additional fee or penalty. Open mortgage rates are generally higher
than closed mortgage rates
• A closed mortgage is for a specific term and borrowers would have to pay a
penalty for prepaying a large amount, closing the loan, or transferring to
another lender.
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CALCULATING MORTGAGE PAYMENTS AND PRINCIPAL BALANCE

A $250,000 mortgage for a house was issued with an amortization

period of 25 years and payments had to be made monthly. The interest
rate on the mortgage was 3.4% compounded semi-annually for a term of
three years.
a. What was the size of the monthly payment?
b. What was the principal balance at the end of the three-year term?
c. What would be the size of the monthly payment if the mortgage is
renewed for another three-year term at 3.8% compounded semi-
annually?

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EXAMPLES

Cindy received a $60,000 mortgage that is amortized over four years.

She negotiated a fixed interest rate of 4% compounded semi-annually
for the term. Payments had to be made on a monthly basis
a. Calculate the size of the monthly payments if they are rounded up to
the next $100
b. Calculate the size of the final payment on the mortgage
c. If payments are rounded up to the next $100, construct the partial
mortgage schedule for the:
i. first two payments
ii. last two payments
iii. total payment made and interest paid

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PREPAYING A MORTGAGE

A mortgage can be settled sooner if the borrower pays an extra amount

over the periodic payment towards the mortgage. This is known as
prepaying a mortgage. Some popular prepayment methods are listed
below:
• Making a lump-sum payment
• Increasing the periodic payment amount
• Increasing the frequency of payments
• Combination of methods
• Reducing the amortization period

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PREPAYMENT PENALTIES

• For open mortgages you can make a prepayment or lump-sum

payment at any time without incurring a penalty
• However, for closed mortgages there may be a prepayment penalty
• For closed mortgages you will incur prepayment penalties if you:
• Increase your payments by more than your mortgage contract allows
• Make a lump-sum payment that is more than your mortgage contract allows
• Refinance your mortgage
• Break your mortgage contract
• Transfer your mortgage to another lender before the end of your term

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EXAMPLES

Benjamin and Hailey purchased a $250,000 apartment in Calgary. They paid 20% of
the amount as a down payment and secured a 25-year mortgage for the balance.
They negotiated a fixed interest rate of 3.6% compounded semi-annually for a five-
year term with payments made at the end of every month. Their mortgage contract
also stated that they may prepay up to 10% of the original principal every year
without an interest penalty. At the end of the first year, in addition to the regular
monthly payment, they made a lump-sum payment of $15,000
a. What was the size of the monthly payment?
b. What was the principal balance after the 12th monthly payment (before they
made the lump-sum payment)?
c. By how much did the amortization period shorten after they made the lump-sum
payment at the end of the first year?

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EXAMPLES

A $450,000 condominium in downtown Vancouver was purchased with

a down payment of 20% of the amount. A 20-year mortgage was
obtained for the balance. The negotiated fixed interest rate was 4.25%
compounded semi-annually for a three-year term with repayments made
at the end of every month
a. What is the size of the monthly payment?
b. What was the principal balance at the end of the three-year term?
c. By how much did the amortization period shorten if the size of the
periodic payments were increased by 15% starting from the 37th
payment? Assume the same interest rate

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EXAMPLES

A $300,000 mortgage at 4% compounded semi-annually is settled with

monthly payments of $1578.09
a. What is the amortization period?
b. Instead of monthly payments, if accelerated bi-weekly payments of
$789.05 are made, what will be the amortization period?
c. How much interest will be saved if accelerated bi-weekly payments
are made, as in (b), instead of monthly payments?

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THANK YOU !

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